Taxes may be one price we pay for living in a civilized society, but there is no reason to pay extra taxes. Surely there are better forms of patriotism. While the IRS will generally get its share eventually, legally postponing the payment of taxes is often a winning strategy for building wealth. One strategy investors can use to postpone paying capital gains taxes on sales of investment property is the use of Internal Revenue Code Section 1031 Exchanges, also known as Starker Exchanges.
The basic idea is this. An owner of property held for productive use - either in a trade or business, or for investment - trades one or more relinquished properties for one or more replacement properties of a "like kind." The IRS then allows the owner to defer the payment of federal taxes on the transaction. The theory is that when a property owner has reinvested the sale proceeds into another property, the investment is still the same and only the form has changed (e.g., a residential duplex exchanged for a commercial building). Of course, when the replacement property is itself sold, taxes will be due unless there is yet another qualifying exchange.
"Like kind" is generally defined broadly, but it is wise to check first that the replacement property will be eligible for tax-deferred treatment.
If the exchanging party actually receives the funds from the relinquished property, the chance to make a tax-deferred exchange is lost, so planning ahead is critical. To avoid this problem, the exchanging party contracts with a Qualified Intermediary (QI). The QI is an independent party to the exchange that is recognized by the IRS. When the exchanging party engages a QI under an exchange agreement, the IRS does not consider the exchanging party to be in receipt of the funds. The sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly to the closing agent who deeds the new, replacement property directly to the exchanging party.
Any Section 1031 exchange requires compliance with strict timeframes. Once the QI receives the funds from the sale of the relinquished property, the exchanging party must identify the possible replacement property (or properties) within 45 days. The exchanging party has a maximum of 180 days in the exchange period (or until the tax filing deadline, including extensions, for the year of sale of the relinquished property) to close on the purchase of replacement property with the funds held by the QI under the exchange agreement.
It is also possible, although a bit more complicated, to carry out a "Reverse 1031 Exchange": the exchanging party purchases the replacement property first, and later applies to this sale the proceeds from relinquished property that is actually sold in a later closing.
Note that taxes are deferred only on reinvested proceeds. Any proceeds received by the exchanging party from the sale of the relinquished property that are not directly exchanged for replacement property are subject to tax.
Section 1031 exchanges are useful tools, but the tax tail shouldn't wag the dog. Sometimes there are business and/or personal reasons not to make an exchange. Would-be exchanging parties should obtain proper advice and weigh all of the relevant tax, business, and personal planning concerns before making a decision.
Patterson Tabert Law Offices helps our clients with the negotiation and drafting of required real estate contracts, counsels them on the pros and cons of different planning options, and aids them with Section 1031 exchanges from the signing of contracts and exchange agreements through the final closings on the properties involved. If you have questions about a possible Section 1031 exchange or any related matters, we welcome your inquiry.
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