To enjoy the beneficial tax treatment, it’s important to note that it doesn’t happen automatically. In order to defer current taxes, both you and the qualified intermediary must enter into a “Qualified Exchange Accommodation Agreement” by signing it.
A qualified exchange of like-kind real estate under Section 1031 of the tax code can be a beautiful tax strategy. In essence, you can exchange one property for another and potentially defer or reduce your capital gains tax to zero or a minimal amount. This has long been a popular and effective tax-saving technique utilized by real estate investors for many years.
“However, didn’t the Tax Cuts and Jobs Act (TCJA) eliminate like-kind exchanges after 2017?”
Yes, but it’s important to note that the TCJA crackdown does not apply to real estate exchanges. This means you can still utilize this powerful tax strategy for investment or business properties, excluding your primary residence. However, you may require the services of a “qualified intermediary” to facilitate the process smoothly.
Background: The tax regulations outlined in Section 1031 are known for their favorable flexibility. For example, you have the ability to exchange a commercial building for an apartment building or vacant land without incurring any tax liability. You would only owe taxes on any boot received as part of the transaction, such as cash or reduced mortgage liability. Essentially, this means that any potential tax owed on the appreciation in value of your property is deferred until you sell the replacement property, if you choose to do so.
Nevertheless, it’s important to note that there are two critical timing requirements that must be adhered to in order to qualify for tax deferral.
- Firstly, the replacement property must be identified within 45 days of transferring the original property.
- Secondly, the replacement property must be received within the earlier of 180 days after the transfer or the due date of the tax return for that year, including any extensions. Compliance with these timing requirements is crucial to ensure eligibility for the tax deferral benefit.
It’s unlikely that you and another property owner will have properties that the other one desires, making an exchange between you two improbable. Such exchanges, often referred to as “Starker exchanges” after a significant legal case that endorsed this practice (Starker, 602 F2d 1341, CA-9, 1979), usually involve multiple parties. By adhering to tax law deadlines, you can still enjoy tax benefits through a Starker exchange, with a qualified intermediary acting as the go-between.
Curious about how it works? Consider this hypothetical scenario involving four parties. Initially, Alan sells the property he’s letting go to Beatrice. Instead of paying Alan directly, Beatrice pays Charley, who acts as the qualified intermediary. Charley temporarily holds the proceeds until Alan identifies a suitable replacement property.
Afterward, Charley utilizes the sales proceeds to acquire the replacement property from Darlene. Subsequently, Charley transfers this property to Alan, thereby finalizing the 1031 exchange.
From a tax perspective, Alan is deemed to have engaged in a tax-free property swap with the intermediary. This is because no actual cash is exchanged between the parties. Instead, the intermediary manages the funds on Alan’s behalf, facilitating the transaction.
Obtaining favorable tax treatment is not automatic. To ensure that you can avoid immediate taxes, you and the qualified intermediary must both sign a “Qualified Exchange Accommodation Agreement.” This agreement should explicitly state that the intermediary is holding the property for the purpose of facilitating a tax-free exchange.
Additionally, the intermediary must agree to comply with all the technical reporting requirements outlined by the IRS. Please note that the qualified intermediary will typically charge a fee based on the value of the properties involved in the exchange.
Thankfully, you don’t have to navigate this process on your own. Your trusted professional advisor can offer the necessary guidance and assistance to help you through the exchange.
We at Investment.org connect you with the best-in-class financial and investment advisors who analyze your goals based on your risk appetite and help you meet them. Our advisors work closely with you and provide the latest 1031 exchange property lists. This list lets you identify the right replacement property in less than three days.
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