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Tax Planning Tip - Using The 1031 Exchange

Many real estate investors have seen a lot of appreciation in their investments. When the time comes to sell your property, it is important to consider the tax implications on the gain.


To determine the the taxable gain on the property you can use the following example as a guide:


The IRS Section 1031 tax deferred treatment of capital gains is one of the best real estate investor vehicles for preserving and building real estate wealth. This provision of the Internal Revenue Code allows property owners to exchange their property for other like-kind property without paying tax on the capital gain. It makes it possible to transfer the financial gain that is realized from the sale of a property into another property without federal capital gains tax at the time of the sale.


Investors know that cash is valuable when you are making an offer on a new property and postponing payment of the tax on your current property allows you to have more cash to put into the new property. The tax deferral is essentially an interest free loan from the government. Any gain from depreciation recapture is also postponed unless you take cash from the sale.


A key to a successful tax-deferred exchange is to set up the 1031 exchange with a facilitator PRIOR to closing on your old “relinquished” property. You will also need to identify your replacement property within 45 days of closing.


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.


Here are the common types of tax-deferred like-kind exchanges:


A delayed or deferred exchange (Starker Exchange) happens when the disposition of the relinquished property and acquisition of the replacement property are part of an integrated transaction constituting an exchange of property. This type of exchange is subject to some fairly strict IRS rules and involves the use of a third-party intermediary. For real property, nearly any type of improved or unimproved real property will qualify for the tax-deferred treatment, including a trade of raw land for commercial rental property.


A build to suit or construction exchange allows the buyer to actually build a building with the funds from selling the old building. Strict time limitations make this exchange a difficult one to accomplish in which a third-party agent is also required.


A reverse or parking exchange is the least common type of tax-deferred exchange out there, but it can work if executed properly. The investor can buy the new property before selling the old property, then sell the old property and defer tax if all of the rules are followed. It also requires a third-party exchange accommodator to facilitate the deal.


As is the case with other tax strategies, it is important to work with qualified tax and legal professionals.


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