One method that can be used to defer tax in Boston, Massachusetts, is to take advantage of a 1031 exchange as set forth by the Internal Revenue Service (IRS). Under Section 1031 of Internal Revenue Code (IRC), home buyers, real estate investors and people purchasing land or commercial real estate can defer tax liability with a like-kind exchange. While this method has not always been popular, the term 1031 exchange has recently worked its way into regular conversation between property investors, brokers and agents. However, many people who are in a position to take the tax deferment still do not understand exactly what like-kind exchanges are and how they can be implemented.
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What Is IRC Section 1031?
Under IRC Section 1031, many property owners can defer tax on capital gains when they sell their commercial land or real estate and use the proceeds to reinvest in like-kind property. However, several important rules are in place that must be followed in order to become eligible for the deferment. This IRS rule is still largely unknown to those buying second homes in Boston, Massachusetts, because it is meant for business investment.
Who Stands to Benefit?
Most people who will realize a net gain from the sale of non-personal property may be able to take advantage of a like-kind exchange. The following types of property could be eligible: commercial real estate, investment property and vacation homes. In addition, property that was previously used for a business but has since been retired may also qualify. However, 1031 exchanges are not normally allowed for property that is meant to be flipped. The investor must be seeking long-term gains through appreciation.
To qualify under Section 1031, you cannot be a property dealer, which is defined as someone who purchases property to hold as inventory or for the express purpose of reselling.
Vacation Homes and Second Homes
It is important to note that a substantial amount of confusion exists about claiming Section 1031 for vacation homes and second homes. Strict regulations exist concerning like-kind exchanges and second homes that must be followed, and the chief of these is that the property cannot be meant for personal use. Until 2008, these regulations did not exist, and nearly any type of property could be claimed as an investment vehicle.
Because so many people who exchanged homes for personal use were taking advantage of Section 1031, the IRS created Revenue Procedure 2008-16, which defines the types of property that are acceptable. The rules for this must be met for two years prior to the exchange and for two years afterward and are as follows:
- The property must be rented for at least two weeks to someone who is not a related party unless it is the relative's primary residence, and he or she is paying rent at the fair market value.
- The property can only be used personally for two weeks or 10 percent of the time it has been rented, whichever is greater.
- If you personally maintain the property, documentation of all maintenance activities must be kept.
- The property must be placed on Schedule E of your federal tax return as income property.
Overview of 1031 Exchanges
When properties are productively used in a business, a trade or for long-term investing, they may be exchanged for other properties that are meant to be used in the same manner. These types of properties are usually considered to be like kind even if they have major differences in type, character or quality, but they must both be located in the United States or a U.S. territory.
Examples of property that may be considered for like-kind exchanges include the following:
- Office buildings
- Apartment buildings
- Rental homes
- Retail space
- Unimproved land intended for commercial use or in a commercially zoned area
In addition, equipment used on a qualifying property that is included in the price at the time of sale may also be deferred of capital gains tax as long as its value does not exceed 15 percent of the value of the larger property.
At one time, Section 1031 deferments could only be claimed when ownership of the two properties was transferred simultaneously, but now, a contract that commits to a future exchange is considered to be equal to simultaneous transfer when it meets specific time requirements and when the sale is facilitated by a qualified intermediary.
Identification Period and Time Limits
Properties for which 1031 exchanges are claimed must meet strict time limits. The exchange is said to begin on the earlier of the following two dates: the date the deed is recorded or the date possession is transferred. The exchange will then end on the earlier of these two dates: 180 days after the exchange begins or the date the exchanger's federal tax return is to be submitted after all extensions have been exhausted.
In addition, if the exchanger has multiple properties included in the exchange, then it begins when the first property is transferred. Weekends and holidays are included in the time limits for 1031 exchanges. When the due date falls on either, the exchange must be completed on the business day immediately prior. The only way that these deadlines may be lifted is in the case of a related disaster as declared by the president of the United States.
The first 45 days of the exchange is known as the identification period. Within the identification period, the seller must be able to name one or more replacement properties for the property that was sold. The replacement properties must abide by one of the following three rules:
- Three-property rule – According to this rule, you may identify up to three properties as possible exchanges. Estimates show that this rule is invoked in 95 percent of all 1031 exchanges.
- 200 percent rule – You may identify an unlimited quantity of replacement properties as long as their combined fair market value does not exceed 200 percent of the original property sold. To complete the exchange, you only need to purchase properties that have an aggregate value matching that of the original.
- 95 percent rule – Any number of properties may be identified even if the aggregate value exceeds 200 percent of the fair market value of the original property as long as the value of properties purchased is 95 percent or more of the total value of the properties identified.
Other Stipulations of Section 1031
Section 1031 includes several additional stipulations, including the following:
- The name on the title or deed of the property exchanged must match the name on the tax return where Section 1031 deferment is claimed. The only exception is for limited liability companies (LLCs) that have only one member. One of the exchanges may be made in the name of the company, and the other may be made in the individual's name.
- The fair market value of the replacement property must be equal to or greater than that of the property sold to defer 100 percent of the tax. If excess cash is received from the sale, it will be taxed as a capital gain.
- Transactions made with related parties must abide by several rules. The sold property must be held for two years before selling, or in the case of purchasing, the related party must also be engaged in a 1031 transaction.
- The amount of the mortgage or other debt on the property exchanged must be considered. If your debt liability decreases as a result of the exchange, the amount will be classified as a taxable capital gain.
- All funds must be transferred to and held by a qualified intermediary, which cannot be a relative or agent of either exchanging party. A real estate agent may serve as a qualifying intermediary if he or she has not represented the exchanger in two years or longer.
Eight Steps to a Successful 1031 Exchange
- Receive advice from or retain the services of a certified public accountant (CPA).
- Sell your original property. A cooperation clause explaining that the buyer is aware of the seller's intention to file an exchange based on Section 1031 should be included.
- Contact a qualified intermediary, and enter into an exchange agreement. An amendment to any escrow must name the qualified intermediary as the seller. The deed will still reflect the name of the actual seller.
- When the sale closes, proceeds go directly to the qualified intermediary, usually in the form of a segregated money market account.
- Identify the replacement property to the qualified intermediary. The identification must be made in writing within the time limit for the exchange, and it must be signed by each party named in the exchange agreement.
- Enter into a contract to purchase the replacement property. As when selling, the agreement should include a cooperation clause. An amendment to the contract names the qualified intermediary as the buyer, but the name on the deed will be that of the true buyer.
- When the sale closes in the name of the qualified intermediary, the funds are forwarded to escrow. The qualified intermediary is then responsible for delivering a final accounting to the taxpayer.
- When filing a federal tax return, you must complete IRS Form 8824 and any other documents required for your state taxes.
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