Tax Deferral For Investment Property Transactions With A 1031 Exchange

A tax deferred exchange makes it possible to avoid paying capital gains tax when moving investments between two similar types of property. Without this tax deferral, tax would have to be paid when one investment property was sold, even if the intention was to use the money to buy another investment property of the same kind. By using a tax deferred exchange, it is possible to avoid paying any capital gains tax until the final property is sold, without replacement. Avoiding capital gains tax will allow more money to be retained and invested in the replacement property.

A like-kind investment property is one that is intended to be used for a similar purpose as the original investment property, for example, a real property that will be used for business, trade or investment purposes. For example, a house that is rented out can be exchanged for a retail property since both are intended to be run for business purposes. The properties must lie within the United States. Investments that would not be considered as like-kind exchanges for a property include stocks, bonds, certificates of trust, trade or property that will be sold on, or an interest in a partnership.

In order to benefit from a delayed exchange it is necessary to fulfill certain criteria. For example, the exchange must take place within the specified time limit. The replacement investment property must be identified in a maximum of 45 days and the purchase of this property must be closed in a maximum of 180 days after the sale of the original property is closed. If a tax return is filed before the end of this 180 day period, then the purchase must be closed by the time the return is filed.

None of the proceeds that are generated from the sale of the investment property can be kept by the investor. They must all be used to buy the replacement investment property. The money will not pass into the hands of the investor at any time during the exchange. Instead, it will be held in the temporary possession of a qualified intermediary. This intermediary cannot have worked as an agent of the investor. They cannot, therefore, have acted as the investor's broker, attorney or employee in the two years before the exchange. Relatives and controlled corporations are also excluded from acting as intermediaries. The usual intermediary in such a transaction will be a trust company, title insurance or escrow. It is important to choose a trustworthy and reliable qualified intermediary.

The main advantage of a 1031 tax deferred exchange is in the savings that are made when capital gains tax does not have to be paid. The money can be used instead to purchase a higher value replacement property. The 1031 exchange is the only way to defer all taxes when transferring an investment between two like-kind properties. However, all of the money must remain invested in order to benefit from the tax deferral, so a 1031 exchange is not suitable if some of the funds need to be released. Another disadvantage of the 1031 exchange is that a fee will need to be paid in order to perform the transaction.

It is a good idea to consult with a Tax Attorney or CPA before arranging a 1031 tax deferred exchange. If you decide to proceed with the exchange, you will need to add an exchange addendum to the contracts for buying or selling real estate and to notify the qualified intermediary. The exchange agreement will need to be arranged with the intermediary, who will need to be kept informed of all developments. You will need to make sure that the proceeds of the sale are transferred directly to the intermediary when the sale is closed, and you will then need to notify them of the replacement properties within 45 days. Within 180 days, you will need to close the purchase of the replacement property and ensure that the intermediary transfers the money.