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IRC Section §1031 Exchange
General Rules and Timelines
What is an IRC Section §1031 Exchange?
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” - IRC Section §1031
Whenever you sell a business or investment property and you have a gain, you generally must pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
Meet Arthur and Linda Blank
Investment Real Estate Owners
Arthur and Linda have owned a multifamily property for the past 10 years which has appreciated significantly and provided stable monthly income.
They are both turning 65 next year and would like to eliminate all real estate management responsibilities. Since their property has appreciated in value they feel now is a good time to sell.
Their objective is to maintain the income they have been accustomed to and leave as many assets as possible to their daughter Jane upon their passing.
A friend has told them that doing a 1031 exchange could help defer taxes and allow them to keep their full equity base intact to maximize future income. They would like to know what a 1031 exchange is and what their options are.
Option 1 - Taxable Transaction
Sell the property, pay the taxes and use the proceeds to invest in another income producing asset
Upon sale of the property Arthur and Linda would be subject to sizable taxes on their capital gain
After-Tax Proceeds
Taxation on sales proceeds would diminish the equity base used to generate future income.
Potential Real Estate Taxes
-
Federal Capital Gains Tax
-
Depreciation Recapture
-
State Tax
-
Net Investment Income Tax
Option 2 - 1031 Exchange
Upon the sale of the property, Arthur and Linda would have the proceeds of the relinquished property sent directly to a Qualified Intermediary. The clock starts ticking!
The Qualified Intermediary (QI); also known as an exchange facilitator; maintains cash proceeds in an escrow account and helps to ensure that all 1031 requirements are met
1031 Exchange Process& Timelines
Property Sold
45 Days to identify replacement property
180 Days to close escrow on replacement property
Exchange
Timeline
Properties must be "like Kind". Generally, any real estate held within the United States for business or investment purposes is considered like-kind regardless of type, grade or quality.
Property
Requirements
The QI officially records the date and time of property identification prior to midnight on the 45th day
The QI uses the proceeds from the relinquished property to close escrow on the replacement property prior to midnight on the 180th day
Role of the QI
Property Identification Rules
When identifying replacement property an investor can utilize one of the following rules:
3 Property Rule - Identify up to three potential replacement properties and purchase any (or all) of them, regardless of their total value, to complete the exchange
200% Rule - Identify more than three potential replacement properties if their combined total value does not exceed 200% of the value of the relinquished property. Purchase as many of the identified properties as one wants.
95% Rule - Identify any number of potential replacement properties regardless of their value as long as at least 95% of the total value of all of the properties identified are purchased
To Defer Taxes Fully
○ All proceeds from the sale of a relinquished property must be reinvested in replacement property
○ An investor must assume an equal or greater amount of
debt than that which was held on he relinquished property
○ The title on the replacement property must be identical to that of the relinquished property
These are just a few of the considerations when conducting a 1031 exchange. Please consult your Tax Advisor and Qualified Intermediary for more information regarding IRC Section 1031 exchange rules and regulations. Alternative Wealth Management does not provide tax or legal advice.