Breckenridge Real Estate: WINNING WITH IRC SECTION 1031 EXCHANGES

By Robert HB Buckner

What does investing in real estate have in common with the game of Monopoly? Winning at both requires acquiring the most valuable real estate by trading less desirable properties for more attractive ones. For New England real estate investors, it's easier  to finish a winner by understanding the benefits of Internal Revenue Code Section 1031 tax deferred exchanges.

Tax deferred exchanges have been a part of the tax code since 1921 and are one of the last significant tax advantages remaining for real estate investors! One of the key advantages of a 1031 exchange is the ability to dispose of a property without incurring a capital gain tax liability, thereby allowing the earning power of the deferred taxes to work for the benefit of the investor (Exchanger) instead of the government.

Basic Tax Deferred Exchange Requirements

Although many investors mistakenly believe an exchange is a "swap" of properties, most exchanges completed in the 1990's are variations of a "delayed" exchange. By employing what the IRS calls a "Qualified Intermediary", the procedure simply converts a sale and subsequent purchase of investment real estate into a tax deferred exchange.

Requirement #1: Both the sale property (relinquish) and the purchase property (replacement) must be held for investment or used in a business. Properties which are clearly not like-kind are an investor's primary residence or property "held primarily for sale". For example:

?        Stewart owns two rental houses in Waltham. He can sell them, and buy  a small apartment building in Medfield;

?        Sarah owns five acres of developable land in western Massachusetts. She can sell it, buy a vacation rental in Conway, and not pay tax on the gain from her Massachusetts property;

Requirement #2:  The IRS requires an investor to identify the replacement property(s) within 45 days from closing on the sale of a relinquished property. The 45-Day Identification Period begins on the closing date. Exchangers have a number of ways to properly identify properties. They may identify up to three replacement properties of any value (Three-Property Rule).  Alternatively, they can identify an unlimited number of replacement properties, if the total fair market value of all the properties is not more than twice the value of the property sold (200% Rule).

Requirement #3: Close on the purchase property by the earliest of either: 180 calendar days after closing on the sale of the relinquished property or the tax return due date for the year the property was sold (unless an automatic filing-extension has been obtained).

Requirement #4: The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved middleman called a "Qualified Intermediary." The Qualified Intermediary documents the exchange by preparing the necessary paperwork (Exchange Agreement), holding proceeds on behalf of the Exchanger, and creates the exchange between the investor and the Qualified Intermediary. It is recommended that an Exchanger work with an experienced and financially secure company.

Note: To defer all capital gains taxes, an Exchanger must buy a property or properties of equal or greater value (net of closing costs), reinvesting all net proceeds from the sale of the relinquished property. Any funds not reinvested, or any reduction in debt liabilities not made up for with additional cash from the Exchanger, is considered "boot" and is taxable.

Unlike those playing Monopoly, real estate investors don't have to depend
upon a "roll of the dice" to pass GO and collect more money. Savvy property owners in New England are utilizing tax deferred exchanges to acquire the desirable "Boardwalk"
and "Park Place" properties and win the investment game!

Robert "HB"  Buckner is the New England Division Manager for Asset Preservation, Inc., a subsidiary of Stewart Title Company. Questions regarding exchanges can be directed to him at 877-845-1031.