I hope that I never receive the following message, “Hey Phil. I just sold that office building that I’ve held for years and made a huge profit. I’ve heard that I can buy new property and not have to pay any taxes. Just let me know what I need to do next.”
If I could turn back the clock and have that call arrive before the property is sold, then we have an opportunity to help structure the deal to minimize any tax implications. Unfortunately, when the sale has already occurred, there is not much that can be done to minimize taxes. Additionally, a portion of the gain may be subject to a higher capital gain rate for the depreciation claimed in prior years.
Under Internal Revenue Service (IRS) Code Section 1031, a taxpayer has the opportunity to defer the recognition of a gain from the disposition of real estate held for business use or for investment purposes by entering into a like-kind exchange. And more importantly, you’re able to defer paying tax on the sell. Prior to 2018, the same deferral was available for exchanges of personal property. Due to changes made in the Tax Cuts and Jobs Act (TCJA), tax free exchanges now only apply to exchanges of real property.
Under Section 1031, no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if such property is exchanged for property of a like-kind. In order for the gain to be fully deferred, the exchange must only be for like-kind property. Any receipt of boot (cash received or liabilities relieved in excess of liabilities assumed) will result in partial gain recognition. For example, if you exchange property worth $400,000 for property worth $300,000 and receive $100,000 cash, then a portion of your gain will be taxable due to the cash that you received.
The rules for effecting an exchange are very specific and there are date limitations that must be met. The IRS insists on strict adherence to the specified dates. It is imperative that you use a qualified intermediary (a third party that holds the exchange funds between the sale of your property and the purchase of your replacement party) and enter into an exchange agreement prior to the sale of your property in order to complete any exchange.
Exchanges can be structured in several different ways. Three of the most common structures are:
- A direct exchange is an exchange of two properties between two taxpayers and is entered into when you’ve already identified the replacement property.
- A deferred exchange can be entered into when you have a buyer for your property, but the buyer doesn’t hold any property that you want to exchange for and you haven’t identified any replacement property yet. Details are provided below regarding the structure and timing of this type of exchange.
- A reverse exchange can be arranged when you have identified the property that you want, but do not have a current buyer for your property. The replacement property is acquired before the sale of your property to a third-party buyer.
One of the most common methods is the deferred exchange. The taxpayer’s property is sold and the proceeds are received by the qualified intermediary. This is important so that the taxpayer does not have constructive receipt of the sale proceeds. The taxpayer must identify potential replacement property within 45 days and must actually receive the like-property within 180 days. The qualified intermediary uses the sale proceeds from the sale of your property to purchase the replacement property.
The rules for effecting a like-kind exchange are strict and there are other limitations that must be considered such as related party exchanges. Additionally, there may be times when an outright sale would be more beneficial to you than an exchange. However, if a like-kind exchange is better and you can structure the deal appropriately, then the benefits of tax deferral on the gain will be worth the trouble.
So, if you’re ever ready to sell that real estate property, please give us a call when you’re contemplating the sale. We can help to guide you through the process that will give you the best tax result. Start Here.