A powerful tool that can work to your financial advantage.
When you sell your interest in an investment property and buy another, you may face a large capital gain and the prospect of paying federal taxes on it- and in some states, state taxes as well. So your attorney, tax advisor, or real estate professional may suggest a tax-deferred exchange under Section 1031 of the Internal Revenue Code.
A 1031 Exchange allows you to dispose of investment properties and acquire “like-kind” properties while deferring federal capital gains taxes. Most states with a capital gains tax offer a similar tax advantage, too. Bottom line: a 1031 Exchange lets you reinvest sale proceeds that would otherwise be paid to the government as capital gains taxes.
Let's assume you acquired a property for $800,000 four years ago. It has a current mortgage balance of $600,000 and has appreciated to $1,800,000. During the period you owned the property you have taken depreciation deductions of $100,000. Your long term capital gains tax would total $175,000 calculated as follows:
$1,000,000 appreciation gain x 15%= $150,000;
$100,000 depreciation recapture x 25%= $25,000.
|Tax on $1,000,000
appreciation @ 15%
|Tax on $100,000
|Available for reinvestment
|Value of replacement property
assuming 30% down
THE RULES ARE CLEAR AND SIMPLE:
IDENTIFICATION PERIOD The property you're acquiring must be identified within 45 days of the transfer of the first relinquished property.
EXCHANGE PERIOD The acquisition of your replacement property must be completed by the earlier of 180 days from tax return for the year in which the relinquished property was transferred.
TRADING UP To be fully tax-deferred, the property you're acquiring must have value and equity equal to, or greater than, the relinquished property.
YOU MAY IDENTIFY THE REPLACEMENT PROPERTY BY YOUR CHOICE OF THE:
3 –PROPERTY RULE Three properties, no matter what their value, or
200 PERCENT RULE Any number of properties, as long as their combined fair market value isn't more than twice that of all relinquished property, or
95 PERCENT RULE Any number of properties, regardless of their combined fair market value, as long as you acquire 95 percent of that total value.
[STEP 1] PURCHASE CONTRACT-RELINQUISHED PROPERTY
You and your buyer enter into a Purchase Contract with respect to the sale of your property (known as the “relinquished property”). This Relinquished Property Purchase Contract should contain a “cooperation clause” obligating the buyer to cooperate in structuring the transaction as a tax-deferred exchange. Contact us for a sample “cooperation clause.”
[STEP 2] RELINQUISHED PROPERTY EXCHANGE DOCUMENTS
Next, contact First American Exchange to start the tax-deferred exchange process. We will prepare an Exchange Agreement, and Assignment of the Relinquished Property Purchase Contract (assigning your rights as seller to us), a Notice of the Assignment (for delivery to the buyer, it will represent a transfer from you to First America exchange to the buyer for cash. The cash proceeds from the sale for the relinquished property must be delivered directly to First American Exchange. At no time should you be in either actual or constructive receipt of the cash proceeds.
[STEP 3] CLOSING THE RELINQUISHED PROPERTY
When the conditions of closing have been met, your relinquished property will be conveyed to the buyer. While the conveyance will be directly from you to the buyer, it will represent a transfer from you to First American Exchange to the buyer for cash. The cash proceeds from the sale of the relinquished property must be delivered directly to First American Exchange. At no time should you be in either actual or constructive receipt of the cash proceeds.
[STEP 4] RELINQUISHED PROPERTY PROCEEDS AND FORMS
Following the relinquished property closing, First American Exchange will hold the exchange proceeds and provide you with forms to identify potential replacement properties within the 45-day identification period.
[STEP 5] PURCHASE CONTRACT- REPLACEMENT PROPERTY
After you have identified suitable “like-kind” replacement properties and made a decision as to which identified properties you intend to acquire, you will enter into a Purchase Contract with the seller. This Replacement Property Purchase Contract should also contain a “cooperation clause” obligating the seller to cooperate with you in completing your tax-deferred exchange. Contact us for a sampler “cooperation clause.”
[STEP 6] REPLACEMENT PROPERTY EXCHANGE DOCUMENTS
First American Exchange will then prepare an Assignment of the Replacement Property Purchase Contract (assigning your rights as buyer to us), Notice of the Assignment (for delivery to the seller), and instructions to the settlement agent necessary to complete the transaction. All of these documents must be signed before or as of the date of closing.
[STEP 7] CLOSING THE REPLACEMENT PROPERTY
When the condition of closing has been met, First American Exchange will deliver the exchange proceeds to the settlement agent to acquire the replacement property. The seller will convey the replacement property directly to you. This conveyance will represent a purchase from the seller by First American Exchange and a transfer to you in completion of the exchange. Remember that, to qualify for tax-deferred treatment, this closing must occur by the earlier of 180 days from the date of closing on your first relinquished property or the due date of filing your federal income tax return for the year in which your first relinquished property was sold, including extensions.
[STEP 8] KEEPING YOU INFORMED AND FINAL RECONCILIATION
Prior to or at the conclusion of your exchange, First American Exchange Company will provide you with a copy of your exchange documents, including a statement reflecting the receipt and disbursement of all exchange funds. With this information, you and your tax advisor will complete Form 8824 to be filled with your federal income tax return, as well as any state forms required to report the transaction as an exchange.