How the 1031 Tax Deferred Exchange Can Affect Your Real Estate Investment
Since the Tax Reform Act of 1986, real estate investors have faced one big problem on the sale of their property: higher taxes. Upon the sale of an investment property the full amount of the gain is taxable at either short term or long term tax rates, depending upon the holding period for the asset. One technique available to defer taxes and maximize the funds available for reinvestment is the Tax-Deferred Exchange. There are many aspects of a Tax-Deferred Exchange so we will be breaking these down into three main areas over the course of three blogs: limitations, trusts and practical considerations. Today we’ll be discussing the limitations of a Tax-Deferred Exchange.
As in all matters dealing with the IRS there are limitations on a taxpayer's ability to avoid taxes, and many pitfalls to avoid. Here are a few of the requirements you’ll need to follow to ensure compliance.
Replacement Property Rules
The tax swap is an exchange of properties, so investment property that is sold (“Relinquished Property”), must be swapped for new property (“Replacement Property”) according to IRS rules in order to qualify for a tax free exchange. One rule is that the Replacement Property must be of “like kind.” While current tax law does not require the new property to be identical (apartment complex for apartment complex), proposed tax law changes may restrict or inhibit many investors from utilizing the exchange mechanism outlined here when obtaining “like kind” property.
The form of ownership is important. A taxpayer who relinquishes property in the exchange must also take title of the Replacement Property in the same form of ownership. For example, a taxpayer may not dispose of property held in the name of partnership and acquire Replacement Property as an individual.
Property Value Rules
The value of real estate relinquished must be less than the value of real estate acquired. The taxpayer must not trade down unless he is willing to pay some tax on the transaction. If a less expensive property is purchased or there is liability relief as a result of the exchange, a prorated tax may be payable.
Mortgage Loan Rules
A portion of a mortgage obligation may be treated as taxable income if the swap results in “liability relief.” If a taxpayer acquires a Replacement Property using all of his cash from the sale/exchange of the Relinquished Property but with a mortgage loan of $15,000 less than what was paid off on the Relinquished Property, the $15,000 difference in mortgage balances would be treated as “boot” and the taxpayer would pay tax on the $15,000.
The exchange mechanism is not available to a “dealer” in real estate. A dealer is a taxpayer who buys, inventories and sells properties to create ordinary income. A relocation company or a home builder is a dealer. A taxpayer who buys for appreciation and tax benefits is not a dealer.
The number of Replacement Properties may be limited by the “3 Property-Rule” and the “200-Percent rule defined in the rules. You may exchange for up to three Replacement Properties regardless of value or, or in the alternative, any number of Replacement Properties provided that the aggregate value does not exceed 200% of the value of the Relinquished Property.
Family Exchange Rules
There are limitations on the applicability of exchanges between family members or related parties. An experienced tax, estate and planning attorney can best discuss with you how to exchange property between family members and business partners.
In our next blog in this series, we’ll discuss the Tax-Deferred Exchange Trust Agreement and how to prepare this before exchanging for a Replacement Property.
This article is intended only for the purpose of providing general information and does not constitute legal advice. By providing this information we are not establishing an attorney-client relationship and nothing contained in this article should be construed to necessarily be applicable to your unique situation. You should always engage the services of an attorney to determine which, if any, legal solutions are right for you.
Davis Law Group