WHAT IS A TAX
Internal Revenue Code
Section 1031 allows you the opportunity to
defer capital gains taxes owed upon the sale
of investment or income property by
exchanging the property for other like-kind
property. The IRS states specific guidelines
that must be followed and a Qualified
Intermediary provides for a safe harbor
SHOULD AN EXCHANGE
This is an individual
decision based on the your overall
investment goals. You may have a financial
or tax advisor, but ultimately you will be
the one writing the check to the Internal
Revenue Service if they decide to sell and
pay the capital gains tax. You should
contact a Qualified Exchange Intermediary
and find out if a §1031 Exchange is right
WHAT IS CAPITAL
Capital gains is the
difference between what a property sells for
and the “adjusted basis” in the property.
When investment property is purchased, the
purchase price becomes the initial cost
basis. If you make capital improvements to
the property, the cost of those improvements
will increase the basis in the property,
adjusting the basis upwards. Depreciation is
a benefit to owning investment property
which allows for a yearly deduction of a
portion of the value of the property
Depreciation cannot be
taken on land. Any depreciation taken is a
reduction in the basis
of the property.
GAINS TAX ONLY 15%?
No. Gain from appreciation
(the increase in your property value) is
taxable currently at a maximum of 15%.
However, the gain from the depreciation is
taxed at 25% depreciation recapture. In
addition, most states will charge state tax.
WHAT IS THE
DIFFERENCE BETWEEN A SALE AND AN EXCHANGE?
A sale is an exchange of
property for cash or other property which is
not “like-kind” to real estate and therefore
taxable. The IRS states that an exchange is
a non-taxable sale because you, the taxpayer
will sell investment property and replace it
with investment property, which is
IRC §1031(a)(1) allows for
the exchange of property held for productive
use in a trade or business or for investment
for like-kind Replacement Property. A myriad
of court cases and IRS rulings have
established the definition of “like-kind”
real estate to be very broad. Examples of
like-kind property include single-family
rentals, multi-unit housing, commercial or
industrial properties, ranches, and bare
land. Provided a property has not been
personally used, such as a principal
residence or second home, it should qualify
for a §1031 Exchange.
CAN THE EXCHANGOR
BE AUDITED BY DOING AN EXCHANGE?
No more than if you just
sold the property. The tax-deferred exchange
has been a part of the Tax Code in one form
or another since 1921. Just like Individual
Retirement Accounts (IRA’s), if you follow
the rules and guidelines, the law allows for
tax deferral until the property is
ultimately sold and you receive the cash.
WHAT’S THE BENEFIT
IF TAXES WILL EVENTUALLY HAVE TO BE PAID?
With proper estate
planning, you may never pay capital gains
tax! There are many tax-planning vehicles
that allow taxpayers to relinquish their low
basis assets (such as real estate) without
paying taxes. Gifts to loved ones,
charitable contributions, and certain
irrevocable trusts are just a few options
available to savvy investors.
Even without a complex
estate plan, if you exchange instead of sell
it will benefit your heirs. Any property
included in a descendant’s gross estate will
be transferred to your heirs with a basis
“stepped-up” to fair market value. This
means that all capital gains in the property
will be wiped away provided the estate’s
value does not exceed the statutory
WHEN AND HOW SHOULD THE EXCHANGE PROCESS
BEGIN? What is a QI?
You must first select a
Qualified Intermediary (“QI”) to facilitate
the exchange. A QI is a professional company
that specializes in processing §1031
exchanges. The QI’s services must be
retained prior to the closing of the
existing property. Waiting until after the
closing will be too late!
The QI is hired to prepare
the exchange documentation and to hold the
sale proceeds during the time between the
sale of the existing property (Relinquished
Property) and the acquisition of the new
property (Replacement Property). The law
requires the proceeds from the sale of the
existing property be kept from your control
until a suitable Replacement Property is
identified and ultimately transferred to you
by the QI.
HOW SHOULD A QI BE
You should select a QI
based on its expertise, experience,
integrity, and years in the exchange
business. Starker Services, Inc. (“SSI”) is
the nation’s largest and oldest
independently owned Qualified Intermediary.
SSI facilitates thousands of exchanges each
year and has been doing so for almost two
HOW ARE THE
EXCHANGE FUNDS PROTECTED?
With longevity comes
stability. SSI offers you two decades of
exchange accommodation experience. In
addition, SSI maintains a $10,000,000
fidelity bond to protect you
from loss. Each exchange account is
segregated which adds another layer of
security making SSI one of the safest QI’s
in the nation. It is also Starker’s policy
that two Corporate Officer signatures are
required to transfer funds at any time.
AFTER A QI IS
CHOSEN, THEN WHAT?
Upon closing the sale of
the Relinquished Property, you must adhere
to two timetables which both begin on the
date the existing property is transferred.
First, you must identify, in writing,
possible replacement properties within 45
days of the closing. The QI will provide you
with a form on which you may list up to
three potential replacement properties of
any value. Once you have completed the ID
form, you must fax or mail it to the QI by
11:59PM on the 45th day.
Second, you must acquire
at least one of the identified properties
prior to the expiration of the 180-day
replacement period. Again, this period
begins on day the Relinquished Property
closes. You may buy more than one of the
identified properties provided if they all
close within the 180-day period.
The inability to acquire
any of the identified properties will cause
an exchange to fail. There is no mechanism
for alternative property selection once the
45-day identification period has elapsed.
CAN CASH BE TAKEN
OUT WHILE STILL DOING AN EXCHANGE?
Yes! However, any cash
received will be subject to capital gains
tax. You may take cash out at the closing of
the sale property or upon completion of the
exchange. Since you will be taxed on any
proceeds being removed from the exchange, it
will also be necessary to determine what
your capital gain would be had you simply
sold your property. If you take cash out
equal to or more than your capital gain,
then you will be paying all the tax owed. An
exchange at this point would be needless.
considering the sale of investment or income
property should first consult your financial
or tax advisor to determine if a
tax-deferred exchange will benefit your
long-term investment goals and retirement
plans. Ultimately, you must decide whether
to take advantage of an IRC Section 1031
exchange or write a check to the IRS!
This material is
provided for informational purposes only and
is not to be construed as tax advice. The
reader is strongly advised to speak with a
tax consultant before attempting to employ
any of the concepts stated herein.