I always encourage real estate investors to learn more ways to save on business deductions and tax credits. An effective tax strategy for property investments is the IRS Code Section 1031. When an investor sells business or investment property, they generally will have to pay taxes on the profit at the time of sale. There are is way to keep most of your profit.
What is a Sec 1031 Tax-Deferred Exchange?
IRS Section 1031 allows a tax-deferred exchange by allowing sellers to reinvest the proceeds into a similar property. Gains are tax-deferred but are not tax exempt. The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. Individuals, C corporations, S Corporations, partnerships (general or limited) limited liability companies, trusts and any other taxpaying entities are eligible under this Section 1031 tax strategy.
Section 1031 is an exchange of like-kind properties. Like-kind refers to the type or character of the property but not its state or quality. The deferred exchange can be a simultaneous exchange of one property for another or a reverse exchange that allows the investor to purchase replacement property before the current property is sold or traded.
Property Exempted From SEC 1031
Both properties must be owned for trade, business or investment and should be similar in nature, character or class. For example, a residential rental house is like-kind to vacant land. However, personal use properties such as a primary residence or vacation home do not qualify nor do real property in the United States and real property outside the United States. In addition, specific types of property excluded from Section 1031 are inventory or stock in trade; stocks, bonds or notes; other securities or debt; partnership interests; and certificates of trust.
SEC 1031 Re-Investment Time Constraints
Two time limits are required or the entire gains on held properties are subject to business tax. The first is that the seller has 45 days from the sale date to identify potential replacement properties in writing, signed and delivered to the replacement property seller or the qualified intermediary. The second is that the replacement property must be received and the exchange complete within 180 days of the sale date.
Deferred and reverse exchanges do have certain restrictions under Section 1031. Taking control of cash or other proceeds before the exchange is complete may disqualify contract and make ALL profit subject to business taxes. If cash or other proceeds that are not like-kind property are accepted at the final exchange, the transaction will still qualify as a like-kind exchange. Any proceeds that are not like-kind property are subject to business taxes. Section 1031 exchanges are reported on the IRS Tax Form 8824.
A method of avoiding early receipt of cash is to use a qualified intermediary (also known as an exchange facilitator) to hold the proceeds until the sale of property is complete. A qualified intermediary will have knowledge and experience with tax codes and regulations; business tax credits and business tax deductions; safeguarding funds such as fidelity bond and an Errors and Omissions Policy to protect the investor's funds and business tax credits; and qualifications such as longevity in the field and membership in Federation of Exchange Accommodators. Investors cannot act as their own agents nor can real estate brokers, lawyers, accountants, current employees or anyone employed by you in the previous two years.
SEC 1031 Tax Strategy Conclusion
Finally, beware of the improper sale or tax scam that supports the exchange of non-qualifying vacation or second homes and market the exchange as “tax-free” or “tax write-off” rather than tax-deferred. Any agent that advises you to accept receipt or business tax credits before the conclusion of the exchange is not promoting a professional tax strategy for your business.