This Time, the IRS Is on Your Side!
Have you heard about the recent 1031 exchange controversy in the cryptocurrency world? Crypto-traders are fuming that cryptocurrency trades can no longer qualify as “like-kind” exchanges.
Previously, traders classified cryptocurrency-to-cryptocurrency trades as “like-kind” exchanges in order to defer capital gains taxes.
Now, “like-kind” exchanges must comprise only “real-property” exchanges. This is where things get interesting. Real estate investors and business owners want to make maximum profits while minimizing current tax liabilities, that’s a given.
The IRS allows businesses to roll all capital gains taxes (CGT) due on the sale of a piece of real estate into another piece of real estate. Basically, instead of paying capital gains taxes from the first sale, you reinvest your proceeds to purchase a second piece of property.
Of course, all legal requirements must be met regarding such as exchange, but by following those rules, all CGT due can be deferred – again and again – until you stop purchasing properties. At that point, all deferred CGT becomes due and payable. The process you follow to defer CGT is called a 1031 Exchange.
What Is a 1031 Exchange?
The rules pertaining to a 1031 exchange is covered in Section 1031 of the IRS Code, hence the name. The IRS says that one or more pieces of real estate held for business or investment purposes may be “exchanged” for one or more pieces of “like-kind” property of equal or greater value. Before we proceed, there are two things you need to know.
Like-Kind Property in a 1031 Exchange
“Like-kind” means just what it says. It can be real estate property of any kind, such as vacant land, farmland, an office block, a retail store, condo units that you rent out, etc. All that matters is that it’s real estate held for investment or business purposes.
Here are two examples:
• Farmland owned on the Central Coast can be “exchanged” for a retail store in downtown San Diego
• Single-family rental properties owned in Mid-City can be “exchanged” for condo rental units in Coronado, California.
Meanwhile, equipment, trucks, or even acts of goodwill aren’t real estate. So, they can’t be included in a 1031 exchange. You can still sell them along with the real estate. However, you must pay CGT on that part of the sale. Those items are called “boot.”
The word “boot” originates from the Anglo-Saxon word “bot,” which refers to something of value (like a truck). However, since a truck isn’t the same as a rental unit, they aren’t of “like-kind.”
Relinquishing and Acquiring
- When you sell a property using 1031 exchange rules, it’s called “relinquishing,” and when you buy, it’s called “acquiring.” So, by relinquishing and acquiring property, you’re technically exchanging one or more pieces of property for one or more pieces of like-kind property.
What Are the Advantages of Exchanging Versus Selling?
An exchange allows you to maximize your purchasing power by deferring CGT on the sale. Secondly, you have up to six months to complete your “relinquishing” and “acquiring” process. This is a little-known feature of an exchange. Since you have up to six months to complete “acquiring” new property and “relinquishing” your currently-owned property, you can capitalize on market trends to maximize your profits. I’ll explain that part next.
What are the Exchange Timelines?
There are three ways to complete a 1031 Exchange:
- You can “relinquish and “acquire” properties simultaneously, so everything is completed at one closing.
- You can relinquish properties and then take up to 45 days to choose possible properties to acquire. You must complete the acquisition(s) within a further 135 days, adding up to 180 days in all. This is known as a deferred exchange. All sale proceeds are held in escrow to avoid CGT liability until all transactions are completed.
- You can acquire new properties and relinquish existing ones within a maximum of 180 days. This is known as a reverse exchange.
Who Manages the 1031 Process?
Normally, a title agent or attorney handles real estate closings. With a 1031 exchange, the job goes to someone called a “Qualified Intermediary” or QI.” The QI handles the total escrow and closing process in an IRS-approved process.
By using an experienced QI, the whole process will flow smoothly. The QI must be someone who doesn’t have a business relationship with the taxpayer (the seller or “relinquisher”). So, you can’t make your own attorney your QI, for example. The QI enters into a written exchange agreement with the seller to:
- Acquire the relinquished property from you, the current owner
- Transfer it to the buyer on the agreed sale and purchase contract terms
- Hold the proceeds in escrow
- Acquire the replacement property from the current owner on the agreed contract terms
- Pay that seller out of escrow proceeds from the original “sale” transaction
- Transfer the title to you
In this way, the process isn’t complicated by a conflict of interests.
You Can Gain All the Benefits of a 1031 Exchange Without the Hassle
If you’d like to take advantage of market trends or immediate business opportunities while deferring CGT, a 1031 exchange may be the way to go. And, if you’d like to work with a real estate expert who has a strong track record in the San Diego real estate market, message me by clicking here. I can make the 1031 exchange process a stress-free one for you.