Exchanges Can Help Build Wealth
Sec. 1031 of the Internal Revenue Code offers real estate owners a way to defer payment of capital gains tax on the sale of investment properties though "exchanges." The rules are complicated and inflexible, yet the Sec. 1031 exchange is a valuable opportunity for owners of investment properties, including rental houses and condominiums.
The chief advantage of an exchange is the ability to defer payment of federal income tax on the capital gain, if any, from the sale of an investment property when the proceeds of the sale are used to purchase another investment property. The tax liability isn't eliminated; rather, it's deferred and becomes due if the acquired or "replacement" property or any subsequent replacement property is sold without the benefit of a Sec. 1031 exchange.
This article is presented only for general information purposes. Investors should obtain professional advice before buying, selling or exchanging real property.
Here are some of the rules for a Sec. 1031 exchange:
Like-Kind - The property being sold and the property being acquired must both be "like-kind," properties, meaning they're owned as an investment and not for personal use.
Boot - To defer the entire tax on the capital gain, the sales price and the equity of the property that's sold must be less than the sales price and the equity of the property that's acquired. Investors can extract cash or other value, known as "boot," from the exchange and pay whatever tax is owed on that amount; however, if the amount of boot is substantial, the exchange might afford the investor little or no tax benefit.
Deadlines - The replacement property must be identified within 45 days and purchased within 180 days after the sale of the exchanged property. The 45-day rule can be difficult for investors because it is a relatively short period of time in which to identify the replacement property. A reverse exchange, in which the replacement property is purchased prior to the sale of the exchanged property, avoids the 45-day rule.
Accommodator - A valid Sec. 1031 exchange requires the involvement of a third-party 1031 specialist, known as an "accommodator." In a delayed or "forward" exchange, the accommodator holds the cash from the sale until the replacement property has been purchased. In a reverse exchange, the accommodator holds the replacement property until the exchanged property has been sold.
Some accommodators charge set fees for their services while others retain a portion of the interest earned on the cash they hold for the investor during the exchange. Fees for a forward exchange typically range from $500 to $1,500 or more, depending on the value of the properties and other criteria. A reverse exchange or an exchange that involves more than two properties generally is more expensive due to the greater complexity. There may be additional fees to set up an account, cancel an escrow, send documents by courier or overnight delivery, wire money, store documents, retrieve documents from storage or other services.
Remember that an exchange allows the deferral of capital gains tax, but it doesn't eliminate the tax altogether. There are two other ways to eliminate, rather than defer, all or part of the capital gain tax liability on the sale of real property. One is that $250,000 of capital gains tax for an individual or $500,000 for a married couple can be eliminated if the investment property is converted into the owner's primary residence and other tests are met. The other is that a capital gain can be eliminated if the owner dies and his or her heirs receive the automatic stepped-up tax basis, which wipes out the capital gain. Consult a tax professional for more information.
Accommodators caution that property owners shouldn't focus on tax postponement so much that they lose sight of their investment goals. The rationale for a Sec. 1031 exchange should be to obtain another property that is a better investment for the owner.
Copyright 2006. Marcie Geffner. All rights reserved.
COMING NEXT ISSUE:
Are real estate seminars worth the price? Read this potentially valuable story for interested investors, coming up in the next issue.
The Investor e-Newsletter is provided free by HomeVestors of America, Inc.
HomeVestors of America
The HomeVestors Real Estate Investors Hour is a new radio show about how to invest and build wealth through real estate. The show can be heard every Sunday at 8 a.m. CST. Log in to www.homevestors.com to hear the show live, or listen to previous broadcasts. For franchise information, call 1-866-249-6932.
If you have a question, comment, or an idea for our newsletter, please click here.
