How to defer taxes on the sale of your investment properties
FEARING that the real estate market may weaken, real estate investors are selling their appreciated properties in large number, paying tremendous amounts in capital gains on the sales. This has proven a boom for tax authorities.
A smarter move for real estate investors is a Section 1031 exchange, which allows investors to lock in their gains in real estate and shift into other investments without the accompanying tax payment to the IRS and the state. Many call this transaction the "best-kept tax secret."
In fact, for many real estate investors, transferring their property in a Section 1031 transaction could save them from having to pay any taxes on the "sale" of their property. Section 1031 governs tax-deferred exchanges of "like-kind" property. A Section 1031 exchange is a method for you to (in essence) sell your property and reinvest the proceeds into other properties without the burden of paying taxes. The simple theory is that when you reinvest the proceeds from your sale, you have the same (or similar) amounts invested, only in a different property or properties.
THERE ARE two tax advantages of structuring your sales transactions to meet the Section 1031 exchange requirements.
» First, you can defer paying taxes on capital gains on the appreciated value of the property transferred.
» Second, you can postpone paying tax on any gain on depreciation recapture that would normally arise in a sales transaction of investment property.
To receive a tax deferment on a Section 1031 exchange, a number of requirements relating to what properties qualify and timing of the transaction must be met.
» Property eligible for a Section 1031 exchange is defined as "property held for productive use or investment." This means any property used in a trade or business or any property held as an investment. However, certain property is specifically excluded by the IRS such as inventory, property held primarily for sale, and stocks, bonds or notes.
» Qualifying property must also be of a "like-kind" nature. This means the property given up (relinquished property) and the property obtained (replacement property), must be similar in nature, classification or characteristic. Generally, real property can be exchanged for other types of real property (e.g. a house for an apartment, or an apartment for an office).
THERE ARE two time frames that affect Section 1031 exchanges: the exchange period and the identification period.
» The exchange period is 180 days, starting at the sale date of relinquished property. During this time the entire exchange must be completed to qualify for tax deferral.
» Also starting at the sale date is the identification period, which is 45 days. During this time the replacement property must be identified in writing.
If either of the time frames are not met, the exchange will be treated as a normal sales transaction and may be subject to taxes.
ONE important note is that Section 1031 exchanges are tax-deferred, not tax-free. When you acquire replacement property, you have the same basis in the new property as you did in the relinquished property. When you eventually sell the replacement property, you will pay tax on the capital gains and depreciation recapture that you originally postponed in the Section 1031 exchange.
However, if you continue to exchange properties following Section 1031 requirements, you can potentially postpone your tax liability indefinitely.
Additional issues affect a Section 1031 transaction. The major issue is the receipt of cash or other property that is not "like-kind," which is taxable. The ability to utilize a "qualified intermediary" to facilitate the transfer of the properties is a consideration. In these transactions, coordination between your accountant, attorney and qualified intermediary is crucial for a successful, and tax-free, Section 1031 transaction.
Alan M. Schlissel is a tax manager in the Honolulu office of Grant Thornton LLP. He can be reached at Alan.Schlissel@gt.com