At my open house this weekend a couple came through and were in the middle of a 1031 exchange. As this is something I am very familiar with we had a nice discussion about what exactly like property is and where the best place for them to exchange would be in the East Bay.
Now a number of other people were also at this open house at the same time and did not know what a 1031 exchange is so today I thought I would share some of an article by Leonard Spoto from the Asset Exchange Company.
In a nutshell a 1031 exchange is when the seller of an investment property defers their capital gains taxes on the sale provided they buy another property or properties to hold as investment.
A basic premise of 1031 exchange is that the taxpayer who sells relinquished property must be the same taxpayer who buys replacement property. This usually means that the vesting is the same for both the relinquished and the replacement properties. For example, John Doe's name is on title to both properties involved in the 1031 Exchange.
However, there may be times when the party involved in the exchange would like to make a change in how the replacement property is held. For example, John Doe is on title to the relinquished property, but would like to take title to the replacement property in an LLC.
This is only allowable if the LLC is treated as a pass through entity, disregarded for tax purposes. The tax ID for the LLC will be the taxpayers social security number and there will be no need to file a separate return for the LLC.
This works for an LLC, but also for a revocable living trust, since living trusts are also pass through entities for tax purposes.
The rule of thumb regarding a 1031 Exchange is to maintain the same taxpayer. The taxpayer who sells relinquished property needs to be the same taxpayer who buys replacement property, regardless of the vesting.
Strict adherence to the legal requirements of Section 1031 of the Internal Revenue Code is required for a successful exchange. Investors should be aware of four basic requirements when entering into a delayed exchange, and should seek the advice of a tax accountant or attorney to ensure proper adherence to the tax code. The four basic requirements for a successful exchange are:
1. Property Qualifications
The internal revenue code states that the properties involved in an exchange must be held for productive use in trade or business or for investment, and they must be “like-kind”.
The IRS provides a maximum of 180 days to complete an exchange. The timeline begins upon the close of escrow (COE) of the relinquished property. The new property (or properties) must be acquired on or before midnight of the 180th day. No Exceptions! In addition, the IRS requires that all potential replacement properties be identified by midnight of the 45th day of the exchange.
Identification of all potential replacement properties is required on day 45 of the exchange. Identification must be in writing and the description of the properties must be unambiguous. The IRS provides two rules for identifying replacement property:
The 3 Property Rule
The 3 Property Rule allows for identification of any three properties, of any price, anywhere in the United States.
The 200% Rule
The 200% Rule is an option for identifying more than three properties. With the 200% Rule, four or more properties can be identified. However, the combined value of all properties identified cannot exceed 200% of the property sold.
4. Tax Deferral
To defer 100% of the capital gains tax liability, two requirements must be met
a. Reinvest all the Cash - all the cash that was generated from the sale of the relinquished property must be reinvested into the new property or properties.
b. Purchase Equal or Greater in Value - the new property (or properties) must be equal or greater in value to the property sold.