1031 Exchange Program
First, what is 1031 like-kind exchange program?
When a property owner( or tax payer which I will use them interchangeably, in fact, this topic can be handled by tax accounts in much better way), anyway when he/she accumulated preferably large equity from an investment property and he/she is trying to sell the property, the owner is facing to pay a substantial capital gain tax. In other words, federal government will impose the tax on the gain between the purchase price while back and current selling price of the property. However, by IRC( Internal Revenue Code) section 1031, so called “1031 like-kind exchange program” the property owner can defer this capital gain tax if the property owner is willing to buy other like-kind property right after the subject property has been sold. In fact, this deferral program works indefinitely because the program can be used repeatedly. And also it serves as Estate planning opportunities because heirs receive the assets at a stepped-up basis.
Second, how does this program work? What is basic time line?
Property owner has to identify the building to buy, called Replacement property in 45 days after property owner closes the transaction of his/her own property, called Relinquished property. And further, owner has to close the transaction of Replacement property in 180 days. Here one thing needs to be careful about the funds out of his/her own property’s closing. IRS requires this money to be held and escrowed into a trust worthy person, called Intermediary. Intermediary can be an attorney, or real estate broker, or Tax Accountants, etc. In order for real estate broker to be an intermediary, that broker did not have any transactions with the tax payer for the last 2 years (You have to be careful that the intermediary will not use this funds for his/her own purposes and it needs to be liquidated all the time)
Third. What kind of building could be the replacement property, that is, what does ‘Like-kind’ really mean?
It is very broadly defined. It allows the tax payers to trade between raw land, retail, office, warehouse/industrial, residential rental, etc. And also there are some basic rules when you choose replacement properties: 3 property rule and 200% rule. You may choose up to 3 replacement properties. When you choose more than 3 properties, the total aggregate value of all replacement properties cannot be more than twice of relinquished properties, called 200% rule.
Last, what are the odds?
Well if the property owner cannot identify the replacement property within 45 days and changed mind/gave up the exchange program. Can he/she get the money form the Intermediary right away? Answer is no. Property owner can get the money only 45 days. Another case, if the property owner identified replacement property in 45 days, but changed the mind not to close it. Again in this case, property owner has to wait for 180 days to get the money back.
Another case is tax payer hits tax reporting dead line before his/her exchange program’s 180 days time window. In this case, obviously tax payer should finish his/her exchange program which means closing before tax reporting dead line. Otherwise, tax payer should file extension. Another interesting situation is that property owner could find really good property to buy first before he/she could close his/her own property. The property owner can close on the replacement property first, called Parked property if he/she has enough funds and it is called Reverse Exchange. If we call this reverse exchange, then we call the standard exchange talked about so far Forward exchange. Well, reverse exchange makes sense because many investors are afraid of difficulties on finding property to buy in 45 days and close it in 180 days. IRS allows reverse exchange and in this case, property owner should identify the selling property in 45 days after the parked property has been purchased first and close the property, relinquished property in180 days. Again intermediary should handle the title of parked property.
NAR(National Association of Realtors), we have about 1.2 million members in US, is continually promote our political opinion through NAR lobbing team in DC about this 1031 exchange program and tax deduction on mortgage interests and property tax because we do not want to have any changes on them in the tax reform process, and because we need them.