As of posting this, the IRS has released Notice 2020-23 to address the affects of the ongoing Coronavirus Pandemic on taxpayers. With this update, taxpayers with a 45-Day Exchange Period or 180-Day Exchange Period deadline between April 1 and July 15, 2020 will have an automatic extension to July 15th.If you have any questions about this update, please do not hesitate to reach out. We would be honored to help you navigate this season.
-Linville Team Partners
The last few years have seen a rapid increase in real property values throughout the country. Many taxpayers who own investment or commercial real estate may be reluctant to sell their property when faced with the resulting capital gains tax consequences.Section 1031 of the federal tax code provides a method of structuring a sale of qualifying property followed by a purchase of “like-kind” property as a tax-deferred or like-kind exchange. If structured in advance with a Qualified Intermediary, the taxpayer has 45 days after the relinquished property closing to identify replacement property, and 180 days to actually close on the replacement property.
A properly structured like-kind exchange allows the taxpayer to relinquish his old property and acquire replacement property without recognizing taxable gain. For illustration purposes, assume that a taxpayer owns an office building that he intends to sell for $500,000.00. The property has an adjusted basis of $200,000.00. He wants to acquire a new office for $600,000.00. If structured as a sale rather than an exchange, he would pay state and federal capital gains taxes of at least $75,000.00 that could have been avoided.
Besides saving taxes, what other financial planning reasons motivate an exchange?
Change the property’s location. Many taxpayers structure an exchange to physically move their qualifying property. A taxpayer could move their office to a more suitable location or upgrade to a larger space without immediate tax consequences. Additionally, if a taxpayer moves from one city or state to another, they could relocate qualifying investment or business real property. This technique is particularly useful for owners of rental property who move to another geographic area and want the ease of managing local property.
Change the type of property owned. The definition of “like-kind” is a common exchange misconception. Any real property used for business or investment is “like-kind” to any other real property that is used for business or investment. The business or investment use of the property need not be the same. This enables a taxpayer who owns raw land to take advantage of a tax-deferred exchange, trading it for income-producing rental property. Or, a taxpayer may want to exchange residential rental property for more lucrative office or retail rental property.
Leverage. Some taxpayers use tax-deferred exchanges to leverage their equity in one property, buying multiple replacement properties. For example, a real estate investor began several years ago with one rental house. After a few years, she exchanged that house for three rental houses, tripling her rental income. Subsequent exchanges have substantially increased her portfolio of investment properties, all tax-free!
Retirement planning. A common strategy used among taxpayers planning for retirement is to exchange business or investment property for qualifying rental property. After a few years of qualifying use, the taxpayer may be able to convert the rental property to personal use as their “dream” retirement home. If used thereafter as a primary residence, the taxpayer may ultimately be able to exclude recognition of most of the gain under the capital gain exclusion for the sale of primary residences.
How do I plan for an exchange?
To properly structure an exchange, a taxpayer should seek expert tax advice from a knowledgeable tax or real estate attorney. He should also consult his CPA to discuss tax and basis calculations and reporting requirements. Choosing a competent, experienced Qualified Intermediary company is another essential ingredient for a successful exchange. As the taxpayer’s exchange partner, the Qualified Intermediary must hold the taxpayer’s sales proceeds for the purchase of the replacement property. If the taxpayer is in constructive receipt of those sales proceeds, his exchange will fail. The experienced Qualified Intermediary will understand the tax regulation requirements that prevent the taxpayer’s constructive receipt of exchange funds. Other important considerations when choosing a Qualified Intermediary include whether or not they provide fidelity bonding, document preparation, deadline reminders, and a paper-trail for accounting or audit purposes. Like-kind exchange transactions offer excellent avenues for deferring capital gains taxes. Any taxpayer who owns investment or business property should consider this technique before selling property.
For more information about like-kind exchange transactions, contact Investors Title Exchange Corporation at (984) 364-2752, or visit their web-site at www.invtitle.com/exchange-services. ITEC specializes in assisting taxpayers with 1031 exchange transactions nationally and serves as Qualified Intermediary for thousands of exchanges.
Carol Hayden is an attorney and Certified Exchange Specialist, CES®. She is Executive Vice President of Investors Title Exchange Corporation. Carol has handled 1031 exchange transactions as Qualified Intermediary for more than 25 years. She currently serves on the Board of Directors for the Federation of Exchange Accommodators, the national trade association of qualified intermediaries.