In Part One of this series, we provided an overview of how you can use 1031 Exchanges during real property sales. Section 1031 of the Internal Revenue Code permits some tax-deferral strategies when buying and selling real property. We will now discuss some of the special situations you may encounter in a 1031 Exchange.
It is important to note that the provisions of and the transactions that qualify under Section 1031 are very complex. If these transactions are not handled carefully, the transaction could lose the eligibility for favorable tax treatment. Therefore, it is a good idea to consult appropriate tax and legal professionals before undertaking a 1031 exchange.
In general, a 1031 Exchange allows you to defer capital gains taxes on any profits when you sell real property as long as you reinvest the proceeds from that sale in a replacement property within a certain amount of time.
However, you may not be able to defer all taxes following a sale. For example, if you “trade down” by selling a property that has a higher price than the property you purchase in a 1031 Exchange, this difference in value, known as boot, is taxable. You can offset taxable boot somewhat with the expenses involved in the transaction, such as filing fees, attorney fees, and property tax proration.
The best way to avoid taxable boot is to limit 1031 exchanges to properties of equivalent value, also known as “traded across,” or to transactions where the value of the sold property is less than the value of the acquired property or properties (“traded up”).
A 1031 Exchange must be completed during specific time periods, so it is important to pay close attention to transaction logistics to ensure a qualified exchange.
Arranging the exact timing of a sale of your property so that it coincides with the purchase of another, qualifying property can be very difficult, if not impossible. Fortunately, the IRS allows a delayed, non-immediate exchange under certain circumstances.
First, this delayed exchange must engage a qualified intermediary (QI) that serves as a non-associated party in the various stages of the exchange. The role of the QI is to control the process to assure the proper execution and flow of monies so as not to disqualify the exchange.
Second, a delayed exchange must take place within specific time periods. For example, you must identify the replacement property or properties within 45 days of the sale of the first property. You will need to discuss and plan for the specific percentage rules on what qualifies as “identification.”
The final requirement is that the exchange must be completed within 180 days.
As a tax deferral tool, 1031 Exchange can be used as an effective and compelling tool for estate planning. When properly executed, a 1031 Exchange allows you to preserve the tax-deferred nature of real property assets until the owner’s death. When that happens, a step-up in basis will eliminate all deferred taxes up until the owner’s death and the owner’s heirs will be able to receive the property free of those deferred taxes.
There is no limit on how frequently you can complete a properly executed 1031 Exchange so these transactions can help you shield a significant amount of money from taxes on behalf of your heirs. Even if each 1031 Exchange involves a profit, you have the option of continually deferring taxes on those profits indefinitely or until such time as you can pass these assets on to your heirs and eliminate those taxes entirely.
A 1031 Exchange can be a compelling addition to your wealth management toolkit. Here are a few final points to consider when deciding whether to use a 1031 Exchange.
A 1031 Exchange offers a very specialized and favorable tax treatment if you meet all the required conditions. It is always best to involve an expert in the field of law and taxation when considering or executing such a transaction, as rules and definitions do change from time to time. A 1031 exchange could be disqualified if it does not adhere to all required provisions.
Contact a Blue Chip Partners financial advisor today to learn more about your tax planning options.
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