Capital gains tax is the tax imposed on the profit from property sold. For the properties owned over a year, capital gains tax varies between 22 percent (if the property is individually held) to 30 percent (if the property is held through an entity). The 30 percent was originally higher but under Trump’s tax reduction initiative it has since been reduced.
Talking to many New York real estate attorneys and other real estate professionals, and in light of the new administration, there is concern that capital gain taxes will increase in the next couple of years.
A well-structured 1031 exchange can resolve income tax problems by providing a tax deferral for taxpayers who want to sell their low-basis investment property, but do not want to pay federal and state income taxes.
The main advantages of a 1031 exchange are: an increase in purchasing power, leverages, management relief, increase in cash flow, diversification, and more. Investors can make the most out of the 1031 tax-deferred exchange to obtain a higher-valued investment property.
Section 1031 of the Internal Revenue Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment”.
A 1031 Exchange, also known as Deferred Exchange, is one of the most popular tax strategies available when selling and buying real estate. It allows the owner of a property (Relinquished Property) to defer tax gain on the transaction to a future date and therefore have more cash available for the purchase of new property (Replacement Property).
It is important to note that the like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the Replacement Property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the Replacement Property, is subject to tax.
Rationale and Benefits of 1031 Exchange
The rationale behind the tax deferral is that the taxpayer’s investment is still the same, only form has changed (e.g. vacant land exchanged for apartment building) and it would be unfair to force the taxpayer to pay tax on a “paper” gain.
There are several benefits in doing an exchange instead of selling the property:
· By deferring the tax, the owner has more money available to invest in another property.
· Any gain from depreciation recapture is postponed.
· Owners can acquire and dispose of properties to reallocate the investment portfolio without paying tax on any gain.
Types of Exchanges
· Simultaneous Exchange: when the exchange of the Relinquished Property for the Replacement Property occurs at the same time
· Delayed Exchange (most common): when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. There are strict time limits to follow as set forth in the Treasury Regulations.
· Build-to-Suit (Improvement or Construction) Exchange: the taxpayer can build on, or make improvements to, the Replacement Property using the exchange proceeds.
· Reverse Exchange: when the Replacement Property is acquired prior to transferring the Relinquished Property.
Requirements of a Valid Exchange
· Qualified Use Test – both the Relinquished Property and the Replacement Property must be held either for use in a trade or business or for investment. A sale of business property is not required to be replaced with other business property; it can be replaced with investment property or vice versa. Property acquired for immediate resale or a taxpayer’s personal residence do not qualify.
· Like-Kind Standard – the “Like-Kind” standard is broadly interpreted and easy to satisfy. Generally, while both properties must be held either for use in a trade or business or investment, they do not have to be of the same nature.
· Exchange Requirement – the Relinquished Property must be exchanged for other property, rather than a sale followed by a purchase.
· Reinvest the Equity & Exchange Equal or Up in Value – a property owner must first reinvest all of the equity in the Relinquished Property into the Replacement Property. Second, the purchase price of the property acquired must equal or exceed the sale price of the Relinquished Property.
Opportunity to conduct 1031 Deferred Exchange into Delaware Statutory Trust (DST)
In Rev Rul 2004-86 the IRS ruled that a taxpayer may exchange real property for an interest in the Delaware statutory trust without recognition of gain or loss under § 1031, if the other requirements of § 1031 are satisfied. In DST, the investor owns a fractional interest in a property instead of direct ownership and that fractional interest is managed by a sponsor. The investor takes a passive role in the property, while the sponsor handles landlord duties and other property management tasks. These sponsors are typically large real estate operators, some of whom manage multibillion-dollar publicly traded real estate investment trusts (REITs).
Qualified Intermediary Requirement
IRS regulations are very strict. A taxpayer cannot receive the proceeds or take constructive receipt of the funds in any way or the exchange would be disqualified. The use of a Qualified Intermediary is a safe harbor established by the Treasury regulations. The intermediary acts as a middleman to tie the sale to a buyer and the purchase from a seller as a verified exchange. The safe proceeds go directly to the Qualified Intermediary, who holds them until they are needed to acquire the Replacement Property. The Qualified Intermediary then delivers the funds directly to the closing agent. It is very important that the Qualified Intermediary is contacted prior to closing.
A taxpayer is required to identify the target Replacement Property within 45 days of closing of sale. Properties acquired within the 45-day designation period are deemed to be identified. Replacement Property must be designated in a written document, unambiguously described, signed by the taxpayer and received by the Qualified Intermediary on or before the 45th day.
Within 180 days of closing of sale of the Relinquished Property, or before the taxpayer’s next tax return is due, the taxpayer must acquire the Replacement Property. These deadlines are absolute and cannot be changed or extended.
A 1031 Exchange is a great strategy to defer taxable gain on property but when setting up or completing a 1031 Exchange, taxpayers need to fully understand all the rules and procedures set forth in the tax code. Some of the most common mistakes that occur are:
1) Not looking for Replacement Property soon enough.
2) Not starting a 1031 Exchange on time.
3) Acquiring property from a related party.
4) Overfunding the loan on Replacement Property.
5) Using a disqualified party as a Qualified Intermediary or closing agent.
Avoiding mistakes, knowing how to take advantage of IRS Code section 1031and identifying if your property qualifies for 1031 and what type of deferred exchange works best for you is not easy to navigate. To get more information, get in touch with a New York 1031 Exchange attorney and have your legal questions answered. Contact Sishodia PLLC today online or by calling 833-616-4646 to learn more about your real estate investment options.
Natalia Sishodia, Esq. & Beatrice Raccanello, Esq.
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