A number of requirements must be met to qualify for an exchange for tax deferral, typically involving the services of a tax exchange professional, but a benefit that every real estate investor should know about.
To begin with, though, it is important to note that a tax-deferred exchange does not mean you must actually locate another property owner willing to exchange properties with you, and rather might involve the outright purchase of a property, which is then used in the exchange process. IRS rules require careful compliance to avoid having the exchange treated as a sale instead of a Section 1031 exchange, still, other then the proper structuring and documentation, a Section 1031 exchange may be no different from any other transaction.
Briefly, Section 1031 of the federal tax code provides investment property owners with a means to dispose of one real property asset in exchange for another without having to pay taxes in the year of the exchange. The tax obligation is not vanquished, it will have to be paid someday, but Section 1031 permits the taxpayer to defer federal tax until an actual sale of the property occurs.
The benefit to you as an investor should be obvious. By pushing the payment of taxes into the future with the exchange, you have the full value of the property available to be exchanged, and from a time value of money stand point, the longer your tax payments can be deferred into the future, the greater the present value of that deferral.
Tax-deferred exchanges are complex, however, and as the disclaimer goes, should not be attempted without expert supervision.
First, the property must qualify for a Section 1031 tax-deferred exchange. The asset must be held for the production of income in a trade or business or held as investment property. Property held as a personal residence and property held as inventory are excluded.
Secondly, a tax-deferred exchange involves numbers of requirements that must be met to be eligible for exchange treatment. Namely, only like-kind properties must be exchanged. For example, whereas an apartment building for a parcel of raw land would qualify, a vacant lot for an automobile would not qualify. Moreover, only domestic (not foreign) like-kind properties must be exchanged.
Thirdly, the transfer of one property must be dependent upon receiving a qualified property in return within allotted time. The IRS currently allows 45 days for an acceptable exchange property to be identified and up to 180 days from the initial transfer to complete the delayed exchange.
Fourthly, exchanges involving boot (non-like-kind property) require calculations that are even more complex. For example, if you receive a property with a smaller mortgage then the one you are disposing of, that results in net debt relief and is taxable as boot in the transaction. Properties not of equal value would constitute additional boot.
We could go on.
Naturally, there is more (much more) about 1031 tax-deferred exchanges—there always is when it comes to tax matters—but that is beyond the scope of this author. My intention is simply to acquaint those of you who are real estate investing with Section 1031, and trust it may help your with your real estate investment endeavors.
