By far the hottest sector over the past several years is real estate. Whether it’s your primary residence, beachfront property or traditional investment real estate, we’re seeing increasing values and lots of buying and selling activity. This activity has the potential to create large capital gains taxes…a sure way to take some of the fun out of selling. The good news is that with a bit of planning, in many cases you can keep the taxman at bay by effecting a like-kind exchange. When you exchange one property for a similar property, you may be able to postpone paying the taxes on your profits. The rules are tricky and must be followed exactly. Here are the basics of what you need to know:
Internal Revenue Code Section 1031 governs like-kind exchanges and suggests that, for exchanges of real estate, just about everything would qualify for the tax-free exchange as long as it was held for productive use in a trade or business or for investment and traded for property also used in a trade or business or for investment. For example, exchanging raw land for an apartment building would qualify. In its simplest form, A wants to exchange his property for B’s property of an equal value. The simultaneous closing and exchange of these two properties would avoid the recognition of gains by both individuals. Obviously, it would be extremely rare for there to be an exchange between parties of property of equal value. In most cases, one party will receive property and cash while the other party receives just property. In this case, the party that received cash (called ‘boot’) has a taxable event to the extent of the cash received.
In most cases, the party buying the real estate does not have real estate to exchange and the seller has not identified real estate to use in the exchange. Under this ‘Deferred Like-Kind Exchange’, the law provides special provisions that allow the seller some time to identify and purchase property owned by a third party that can be used in the exchange. For this type of transaction, you will likely need the assistance of a qualified real estate attorney who will act as the ‘Qualified Intermediary’. Your purchaser agrees to allow you to effect a Section 1031 exchange and the Qualified Intermediary holds your property until the exchange is finalized. Once you transfer your property to the Qualified Intermediary, you have 45 days to identify ‘replacement’ property and you must close on that property within 180 days of the date you transferred your property to the Qualified Intermediary. If you fail to identify or close on the replacement property in a timely manner, your property will transfer to your purchaser and you will owe the taxes on your gains. Like-kind exchanges are reported on Form 8824.
It’s important to note that you can use multiple properties for your replacement property but there are additional guidelines that you must follow in this case.
One question that often comes up, “Can I do a like-kind exchange with my vacation property?” This is a grey area of the law with few, if any tax cases offering clarity. Many believe IRS Code Section 1031 applies while others suggest it does not.
There are special rules that govern the taxable gain on the sale of your primary residence, which I will cover next week in part two of this series.