Have we seen the bottom of the real estate market? Based on the number of transactions Ive seen lately, it appears that we are well on our way to making a partial recovery. Thats good news for everyone, as we can begin to see a little healthier return on all of our investments, including real property.
I have also seen a ton of transactions involving investment properties. This could be a result of a couple of factors.
One, the bargain hunters are out in full force, purchasing all sorts of properties that have their prices slashed to the bone. Or, two, people are beginning to see a little more expendable income around, and want to purchase properties as another potential revenue stream.
Whether the reasons are a result of the first or the latter, there is an IRS-sanctioned method for saving some of the capital gains tax on investment transactions. What is the big secret? A 1031 tax-deferred exchange.
What in the heck is that?, you might ask, and right you would be.
See, you would have no idea what one of these transactions would be unless you study the tax code on a monthly basis. And if you do that, you are a better person than I.
A 1031 like-kind exchange (otherwise known as a Starker exchange) allows the exchange of investment or business property for other investment or business purposes. Any rental or investment property in the United States is eligible for a 1031 exchange.
The great thing about the 1031 transaction is that it can be used for any and all property used for commercial purposes. You have a few computers you would like to sell for new ones? Go right ahead. A piece of farm equipment that you would like to get rid of? Be my guest. The company car has seen better days? You know where Im going with this.
However, despite what the current administration purports, the government rarely gives people anything for free, and with no strings attached. Thus, there are a few requirements for a 1031 exchange.
When you sell your property, the replacement property must be equal to, or greater than, the sale price and existing debt of the property being sold and all the equity from the property youre selling must go into acquiring the replacement property. See, you cannot have any dominion or control over the revenues generated from the sale of the property. There are companies, as well as law firms, that will hold said revenues in an escrow account for you while the next stages of the transaction occur.
Once the cash is safely out of your reach, you must identify the replacement property within 45 days of selling your property,and you must close on that property within 180 days from the closing of the first sale or the due date for the tax return for the year of sale. There are a number of forms, although not onerous, that you have to fill out to ensure that a replacement property has been identified, and that a contract has been placed on the replacement property. Once the forms have been filled out, the new property identified and closed upon, then you have your 1031 exemption. Easy as pie, right?
If you dont identify a property within the 45-day time period, or you are unable to settle on the replacement property within 180 days, then the money will be returned to you, and capital gains taxes on the first transaction must be paid. Even if you try it and the transaction does work out, youre only on the hook for a few hundred dollars in document fees.
You can also do a reverse 1031, where you buy a property prior to selling the first property. But this is a great deal more complex, and it requires quite a few extra steps. Only the very savvy real estate investor should attempt such a tricky maneuver. Plus, the cost of doing a reverse 1031 is a little bit more than a few hundred bucks.
With a 1031, you can keep rolling proceeds into new properties over and over without having to pay the capital gains tax. However, at some point, if you just want to cash out of your real estate empire, the bill comes due. So the trick is determining when is the best time to take the chips and go home.
But if you can figure that timing out, and you are fully briefed about the time frames involved, then a 1031 exchange can make some sense and (bad pun alert) and dollars for you.
Christopher L. Markham is a general practice attorney based in Frederick. He can be reached at firstname.lastname@example.org.