If you are a real estate investor, you will periodically sell a property before you have a new property to purchase in sight. It’s a good idea to understand at least the basics of the IRS rules on what is referred to as a 1031 Exchange. This is a tax exemption granted under certain circumstances when you sell one property to buy another as a real estate investor. It will help you avoid a big tax bill.
This exemption does not apply to personal property and not all investment property can be exempted. Only “like-kind” transactions in real estate investing are covered. The IRS defines like-kind transactions as an exchange of real property used for business or held as an investment solely for other business or investment property that is of the same type. In general, these transactions are exempted from the capital gains/losses taxes assessed when selling an investment property. This has been permitted for a while now, but not all business investors know about or understand these rules.
For one thing, machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and intangible business assets that are part of the sale/purchase exchange generally do not qualify for non-recognition of gain or loss as like-kind exchanges. These assets may have appreciable value, and may be subject to taxation, but they cannot be included in the 1031 exemption.
The covered transactions are referred to as 1031 exchanges because they are addressed under Internal Revenue Code Section 1031. The rules in this section are specific, and pertain only to like-kind properties held as a business entity. If the property is not like-kind property or money, you must recognize a gain to the extent of the other property and money received.
One of the main reasons real estate investors should be working with a Certified Tax Planner who understands tax laws is to ensure you don’t overpay capital gains taxes. Not all property is eligible. The IRS has periodically made changes to the exemption rules, and you really should not rely on someone who took advantage of this provision to guide you.
In addition, proceeds of sale being claimed as an exemption under the 1031 Exchange must be held in a special account by a third party. You – as the first party recipient of the proceeds of a sale – may not receive the money even if you immediately transfer it to a third party. The proceeds must go directly to the third party at the closing of the transaction, and must remain in a special escrow account that they hold until the purchase is executed on the other side of the transaction. That third party is typically an attorney or a qualified intermediary, and IRS filings are required.
These points are important because there are large sums of money involved when business investment properties are bought and sold. That means you could owe a lot of money in taxes if this is not handled properly. We have seen cases where the investor has paid nearly one million dollars in taxes that could have been exempted under Section 1031.
Again, these must be discussed and arranged before the transaction takes place. If you are investing in real estate or plan to, we’d be happy to have a conversation with you about this so you can avoid overpaying your taxes. Contact us today to arrange a complimentary conversation.