By Drew23 from Marco Island, FL
The 1031 tax deferred treatment of capital gains is considered one of the best real estate investor methods for preserving and building real estate wealth: This provision of the Internal Revenue Code allows property owners to exchange their property for other like-kind property without acknowledgment of capital gains. It is possible to transfer the financial gain that is recognized from the sale of a property into another property without federal capital gains tax at the time of the sale.
Exchanging properties is not new. The "your property" for "my property" type of direct exchange (i.e., a swap) has been in practice for a long time - it's called a two-party exchange. The difficulty is rarely will you find two owners who each want the other's property. Normally, the other owner wants to sell. This presents a problem if you want to dispose of property to finance the acquisition of new property and avoid taxable gains that would substantially reduce your equity.
The three-way or multi-party exchange was a tax-inspired technique designed to solve the dilemma of a two-way swap. However, these exchanges were fraught with danger. When one or more of the parties would not cooperate with the exchange, the exchange failed. Multi-party exchanges, at best, were difficult and risky. Trying to sell your old property before closing on the purchase of the new property is very difficult. This presents a problem if you desire to dispose of property to finance the acquisition of new property but want to avoid selling your property in a taxable event. A sale would produce taxable gains and could substantially reduce your after-tax proceeds. If you could exchange your property tax-free for the desired property, you could benefit from the fair market value of your property undiluted by income taxes on the sale. In other words, you can use your entire equity before taxes to purchase the Replacement Property.
To solve the dilemma, on April 25, 1991, IRS issued the long-promised deferred exchange regulation-Reg 1.1031(k)-1. It permits you to "sell" your Relinquished Property now and use the proceeds to buy the Replacement Property later. As long as it's done following the rules and using the services of a Qualified Intermediary, you get tax deferred §1031 treatment.
Deferred exchange is considered an exchange in which you transfer qualified property called the "Relinquished Property" and subsequently receive qualified property as consideration. The property received is called "Replacement Property".
The Deferred Exchange Regulation is a taxpayer's dream come true. It works without the buyer of your Relinquished Property or the seller of the Replacement Property getting involved in your exchange. The Reg's secret weapon was the creating of a legal entity called the Qualified Intermediary or QI. This new entity is permitted to serve as your agent and do all the exchange stuff for you without getting you involved in a taxable sale of your old property. By using a Qualified Intermediary to handle your exchange transaction, you can now turn the sale of your property, and subsequent purchase of another "like-kind" property, into a §1031 exchange.
This regulation explaining how to put together the 1031 deferred real estate exchange is a powerful tool and strategy for selling appreciated business, farms, land, and investment real estate without recognition of gain for income tax purposes. It spells everything out-step by step. Just follow the rules and you can sell your appreciated property, use the cash proceeds to buy your Replacement Property and qualify for the full benefits of non-recognition of gain under 1031. The regulation has the weight of law and all parties must follow it-even the IRS.
One of the outstanding features of the deferred exchange regulation is it establishes and defines the Qualified Intermediary (QI) as your vehicle to qualify for the safe harbor procedures you must follow to get non-recognition of gain treatment on your deferred exchange.
It must remain clear that a 1031 Exchange only defers the paying of taxes on capital gains. I have noticed that people associate 1031 Exchange with the magic bullet of real estate investment. This is a dangerous line of thinking because eventually the investor will want to pull out their gains. When this happens they will have to pay taxes.
Investors need to keep this in mind as they flip their capital gains into ever more expensive real estate.
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