Section 1031 of the Internal Revenue Code permits investors to defer the payment of tax on the gain from the sale of property held for productive use in business, trade or investment, provided that the property is exchanged for a “like kind” asset or assets. Perhaps, Most Importantly, and what many forget, is that you must recapture all of your depreciation at 25%. Depending how long you have owned your property, the depreciation recapture could be a larger tax bill than the capital gains tax and I have personally seen where many investors end up paying to the IRS upwards to 50% or more of their total profit on the sale of investment property when combining the capital gains tax and the depreciation recapture tax. The 1031 section of the IRC creates a “safe harbor” that permits the taxpayer to have assurance that the transaction will permit the deferral of the capital gain and depreciation recapture tax liability, if all rules are followed and met.
(must be independent from the transaction so cannot be your current CPA, Attorney or Real Estate Agent etc….)
The Internal Revenue Service requires that the proceeds from the sale of the property held for investment (the “relinquished property”) be held by a Qualified Intermediary (a “QI”) until the replacement property is purchased. The taxpayer must assign to a QI their interest as seller of relinquished property. Keep in mind that a Primary Residence does not qualify for a 1031 exchange. Remember, there are parts of the IRS code that already provide for no taxes on certain amounts of gain depending on your marital status and if you have resided in the home for the required amount of time. Please refer to the Internal Revenue Service specific publication site for specific rules regarding the sale and corresponding tax treatment on the gains of the sale of a primary residence.
Once a Qualified Intermediary is selected, a “Deferred Exchange Agreement” is executed between the taxpayer and Hetsler Mediation & Valuation, Inc., d/b/a Qualified Intermediary Capital Advisors.
It is important to include language in the contract of sale for both the sale of your relinquished property and the purchase or your replacement property that requires the other party to cooperate in the exchange. Typically this is not controversial, as the entire exchange is transparent to your buyer or seller, and there are no delays or costs to them in cooperating. However, please note that if lenders are involved, especially Fannie Mae or Freddie Mac, it is best to let them know ahead of time no matter what side of the sale they are on because they have historically, post-recession, be reluctant to finance a property being purchased with 1031 proceeds. So always talk to any lenders involved at the outset to avoid any future problems.
This is a sample clause that has been successfully utilized over the years: “Buyer hereby acknowledges that it is the intent of the Seller to affect a Section 1031 tax deferred 1031 exchange, which will not delay the closing or cause any additional expenses to the Buyer. The Seller’s rights under this agreement may be assigned to Hetsler Mediation & Valuation, Inc., a Qualified Intermediary, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and Hetsler Mediation & Valuation, Inc., to complete the exchange.”
Use the same clause in the purchaser contract, when acquiring a replacement property; just substitute Buyer for Seller, and vice versa. Also, remember that each state has recommendations as to similar provisions to include that your realtor might already have in their standard contract. In my experience, those clauses are substantially the same in substance and will accomplish the same thing. It is not absolutely necessary to identify us as the qualified intermediary at the time of signing the contract as many clients’ contact us after the contract for the initial sale has been executed. The most important thing is to include the clause in general, even without identifying who your Qualified Intermediary is at the time of executing the contract.
(Please note the 45 day and 180 day times periods run concurrently and have the same start date, the initial close on the relinquished property.
However, please note that your deadline is sooner if tax filing is done before the 180 day expiration. By way of example, if you sell your relinquished property on December 15, 2014, and submit your tax filing for 2014 on April 1, 2015, then the acquisition of the replacement property must happen on or before April 1, 2015, and not the typical 180 days after sale. To avoid this issue; please have your tax preparer file a timely extension.
At the closing of the replacement property, assign the rights in the contract to Hetsler Mediation & Valuation, Inc. and Hetsler Mediation & Valuation, Inc. then signs HUD as purchaser. Deed is direct to Exchanger/Buyer, Hetsler Mediation & Valuation, Inc. never goes into the chain of title.
Value of replacement property must be equal to or greater than the value of the relinquished.
Equity in replacement property must be equal to or greater than equity in the relinquished. (One exception to the second requirement is that an Exchanger can offset a reduction in debt by adding cash to the replacement property closing)
Debt on replacement property must be equal to or greater than debt on relinquished.
All of the net proceeds must be used to acquire the replacement property
If any of these items are not met, a taxable event will have occurred on some level and your tax accountant or tax advisor should be consulted to determine the extent of any potential tax liability.