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A Taxing Situation
As with most transactions involving the IRS, there is more than one “hoop” an investor/taxpayer must jump through in order to insure a successful 1031 Exchange. These hoops include making sure that a property qualifies (like kind), the timing of the exchange, finding appropriate replacement property, and making sure all required governmental forms are filed.
The specific filing requirements that apply are listed below, along with some other taxing situations that might need to be addressed when transacting a 1031 exchange.
Like Kind: An investor must be sure that the relinquished (property sold) and the replacement property (property purchased) qualify for a 1031 exchange. This means that both properties be considered “like kind”. According to the IRS, “like kind” is defined as “held as an investment or used in a trade or business.” Personal residences are excluded from 1031 exchanges as are partnerships, stocks, bonds, business ownership or REITs.
Reporting The Exchange: The Taxpayer must report the exchange on their tax return in the year the “relinquished” property was sold. The IRS will require specific information about the transaction, including descriptions of the relinquished and replacement properties, the date the “replacement” property was identified and the date the taxpayer took possession of the replacement property.
Reporting the Capital Gain: The proceeds from the sale of the replacement property must be allocated between Capital Gain and Depreciation Recapture (Cost Recovery). Recapture is the taxes due on the depreciation deduction taken on the property during the time the taxpayer owned the property if a 1031 exchange is not used. Currently the tax on the recaptured amount is significantly higher than the tax owed on the actual gain in value on the property (capital gain).
Seller Financing: If a seller chooses to carry a note they must pay capital gains taxes on the amount of the note (it is considered “boot”). An alternative to sell the note prior to the close of escrow and use the proceeds within the 1031 exchange (this can be tricky and taxpayers should consult their tax advisor before such a transaction is entered into). An installment sale can also be used. In an installment sale capital gains taxes (along with ordinary income taxes on interest earned) is owed on each installment payment.
The Tax Return: The rule is that an exchanger must identify their replacement property within 45 days of the close of escrow of the relinquished property and close on the sale of that property within 180 days OR on the date that their tax return for that year is due, whichever occurs first. If an investor sells their relinquished property between October 17th and December 31 and needs the full 180 days they will need to file an extension before April 15th.
State Tax Withholding Rules: For non resident property owners some states require that a percentage of the sales price be “withheld” at the time of the sale. The amount of the state tax varies significantly for each state and, generally but not always; there is an exemption for a 1031 Exchange.
Investors should consult their tax and legal advisors and their Qualified Intermediary (neutral party that holds the funds during the exchange) as to tax timing and filling issues both before and during the exchange process.
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