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1031 Tax Deferred Exchange

1031 tax deferred exchange | Layman Nichols attorneyBy Dean ‘Mac’ Nichols, Attorney

What is a tax deferred exchange?
A tax deferred exchange is a method by which a real estate owner trades one property for another without having to pay any federal income tax on the transaction.

In an ordinary sale, the property owner must pay tax on any gain from the sale of the property. But in an exchange, if the taxpayer sells business or investment real estate and replaces it with other business or investment real estate, they can defer the payment of the tax that is normally due on the transaction. This deferred tax can be considered an “interest free loan” from the government. If the taxpayer dies before the replacement property is sold, the deferred tax is never paid because the property receives a stepped up tax basis.

What property qualifies for an exchange?
To qualify for the exchange, you, the taxpayer must trade real estate for other real estate used for business or investment purposes. A personal residence or other personal use property (vacation home) does not qualify for a tax deferral.

Can I delay 100% of the tax?
For an exchange to be totally tax deferred, you must reinvest 100% of the net sales price. The taxpayer selling the property must acquire replacement property that is of equal or greater value and spend all of the net proceeds from the property sold.

What are the disadvantages of exchanging?
There are several disadvantages to using a tax deferred exchange.

1. There will be a reduced basis in the replacement property resulting from the carry-over of the basis of the relinquished property which means that depreciation deductions will be less than if the property had been acquired through a straight purchase. However there are more funds available for the purchase since tax does not have to be paid.

2. There will be increased costs for the transaction which could include additional attorney’s fees, accounting fees, and the intermediary/accommodator’s fees, where applicable.

3. The taxpayer cannot (without tax consequences) use any of the net proceeds for anything other than reinvestment in real property. However, there are methods available to have access to the equity after the exchange has occurred.

General Guidelines for a 1031 Exchange

• The value of the new property must be equal to or greater than the value of the sold property less any selling expenses.

• The equity in the new property must be equal to or greater than the equity in the sold property.

• The debt on the new property must be equal to or greater than the debt on the sold property.

• Constructive receipt of sales proceeds is not allowed during the exchange process.

• Deadlines for identifying and closing on the new property must be followed.

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