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1031 Like Kind Exchanges

This is a tax device utilized by investors who do not reside at the property, but rent it out for profit. There are many rules associated with like kind exchanges, but the basic idea behind it is that you are selling an investment property and buying a new investment replacement property. With depreciation and market value rising, there is most likely a large capital gains tax associated with the sale. To avoid paying capital gains tax now, by rolling the gains into the new property, and following the IRS rules, capital gains tax can be deferred. When the last property is sold, and no qualified replacement is purchased, then tax utilizing the basis of the first investment property and the sale’s price of the last property will be utilized to calculate capital gains tax.

The only way to avoid the capital gains tax permanently would be for the last property being owned at the time of the owner’s death. At the current time, the laws provide that heirs receive real property with a “stepped up” basis. This means that for capital gains purposes, they are receiving the property with a basis of the market value as of the date of death. For example, if the property had a basis of zero with depreciation on the date of death, and the market value was $500,000, then the heirs would receive a basis of $500,000, not zero. Therefore, if the heirs sold the property within six months of the date of death for $500,000, there would be no capital gains tax due.

To do a 1031 Exchange, a qualified intermediary (QI) is necessary. The QI prepares the necessary exchange documents and arranges to hold the purchase price of the first property in escrow pending the purchase of the second property. There are specific time frames for designating a replacement property, and a specific time-frame for closing on the second property from the closing of the first property. If these time-frames are not followed to the letter, the exchange will not qualify as a 1031 exchange. If you try to back date something, the IRS can assess very high fines. If the exchange is done within three business days, a simultaneous exchange can be performed. This is where the checks from the sale are made out directly to the seller on the purchase side. In this way, money does not have to be held in escrow. However, no monies can go into the hands of the exchanger. If any monies are received it is considered “boot” and must be reported to the IRS.

Cynthia M. Burke,

Categories: Real Estate Law