Ordinarily, if you buy an asset and its value appreciates, you must pay capital gains tax when you sell the asset. If you are in a low income tax bracket, no capital gains tax might be due. For most taxpayers, the federal capital gains tax rate is 15% and for some it is 20%. Those rates can result in a significant tax bill. But if your asset is a real estate investment, or you hold the real estate for “productive use” in a trade or business, you might be able to defer capital gains taxes through a “like-kind” or section 1031 exchange.
Section 1031 of the Internal Revenue Code
Congress passed Section 1031 to encourage investment. If you can defer paying taxes, then you are incentivized to invest. But there are limitations on 1031 exchanges, and there are strict rules for them. Aside from the requirement that the asset be a real estate investment or real estate used in a trade or business, you must exchange your property for property of a like kind. In other words, the property you receive in exchange for your property also must be real estate investment property or real estate used in a trade or business.
Simultaneous Exchange: The Classic Situation
The simultaneous exchange is the simplest type of 1031 exchange. This type of exchange takes place when each of the property owners simply swap deeds. This can also take place through an intermediary. The critical thing to know about simultaneous exchanges is that they must take place at the same time, or in other words, on the same day. Chances are that you won’t engage in a simultaneous exchange. How likely is it that two people have similarly valued property and simply want to swap?
Delayed 1031 Exchange
Much more common than the simultaneous exchange is the delayed exchange. In the delayed exchange, the property owner sells his property so that he can buy another, like-kind property. If he hasn’t done so already, the property owner identifies and arranges to purchase like-kind property. Then, at a later time, the property owner acquires the like-kind property he wanted to purchase. Although the transactions take place through an intermediary, delayed exchanges are considered to occur between the two exchanging parties under section 1031.
There are two critical deadlines in a delayed exchange. First, the property owner must find the like-kind property he wants within forty-five days of the date he sells his own property. Second, the property owner must complete the purchase of the like-kind property within 180 days of the sale of his property. If these deadlines are not met, then the property owner cannot defer capital gains taxes.
Reverse 1031 Exchange
A reverse exchange is like a delayed exchange except that the order in which things take place is reversed. In a reverse exchange, an investor buys the like-kind property before selling his own property. The investor must identify which of his properties he will sell in exchange for the like-kind property within forty-five days of the purchase. He must complete the sale of his own property within 180 days of the purchase.
New York Law
New York has an equivalent to a 1031 exchange, but it applies to sales taxes rather than capital gains taxes. If a property owner participates in a 1031 exchange but fails to follow the rules, then the property owner will be subject to New York state income tax, applied to the capital gain realized from the sale. Compliance with section 1031 allows the property owner to defer this sales tax, just as federal law permits deferral of capital gains tax.
Legal and Tax Advice
This brief overview of section 1031 omits many complexities of the complexity of the subject. For that reason, the property owner who wants to take advantage of section 1031 would be well-advised to seek professional assistance in completing the transactions.
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