SHOULD MY CLIENT CONSIDER AN EXCHANGE?
This is an individual decision based on the investor’s overall retirement plan and investment goals. Although they may have a financial or tax advisor, ultimately the taxpayer will be writing the check to the Internal Revenue Service if they decide to sell and pay the capital gains tax.
WHAT IS CAPITAL GAINS TAX?
Capital gains is the difference between what a property sells for and the ‘adjusted basis’ in the property. To put it simply, when investment property is purchased, the purchase price becomes the initial cost basis. If your client makes capital improvements to the property, the cost of those improvments will increase the basis in the property, adjusting the basis upwards. Depreciation is a benefit to owning investment property which allows for a yearly deduction of a portion of the value of the property improvements. Depreciation cannot be taken on land. Any depreciation taken is a reduction in the basis of the property.
ISN’T CAPITAL GAINS TAX ONLY 15%?
No. Gain from appreciation (the increase in your client’s property value) is taxable currently at a maximum of 15%. However, the gain from the depreciation is taxed at 25%. In addition, most states will charge state tax as well.
WHAT IS THE DIFFERENCE BETWEEN A SALE AND AN EXCHANGE?
A sale is an exchange of property for cash or other property which is not “like-kind” to real estate and therefore taxable. An exchange is a non-taxable sale because the taxpayer will sell investment property and replace it with property which is like-kind.
WHAT DOES LIKE KIND MEAN?
IRC §1031(a)(1) allows for the exchange of property held for productive use in a trade or business or for investment for like-kind replacement property. A myriad of court cases and IRS rulings have established the definition of “like-kind” real estate to be very broad. Examples of like-kind property include single-family rentals, multi-unit housing, commercial or industrial properties, ranches, and bare land. Provided a property has not been personally used, such as a principal residence or second home, it should qualify for exchange treatment.
WHAT IS A TAX DEFERRED EXCHANGE?
Internal Revenue Code Section 1031 allows taxpayers the opportunity to defer taxes owed upon the sale of investment or income property by exchanging the property for other like-kind property. Certain guidelines must be followed
WILL MY CLIENT BE AUDITED BY DOING AN EXCHANGE?
No more than if they just sold the property. The tax deferred exchange has been a part of the Tax Code in one form or another since 1921. Just like Individual Retirement Accounts (IRA’s), if your client follows the rules and guidlelines, thelaw allows for tax deferral until the property is ultimately sold and your client receives cash..
WHAT’S THE BENEFIT IF MY CLIENT WILL EVENTUALLY HAVE TO PAY THE TAXES ANYWAY?
With proper estate planning, your client may never pay capital gains tax! There are many tax-planning vehicles that allow taxpayers to relinquish their low basis assets (such as real estate) without paying taxes. Gifts to loved ones, charitable contributions, and certain irrevocable trusts are just a few options available to savvy taxpayers.
Even without a complex estate scheme, a client who exchanges instead of sells will benefit their heirs once they pass away. Any property included in a decendant’s gross estate will be transferred to their heirs with a basis “stepped-up” to fair market value. This means that all capital gains in the property will be wiped away provided the estate’s value does not exceed the statutory exclusion limitations.
WHEN AND HOW SHOULD MY CLIENT BEGIN THE EXCHANGE PROCESS?
Your client must first select a Qualified Intermediary (“QI”) to facilitate the exchange. A QI is a professional company that specializes in processing 1031 exchanges. The QI’s services must be retained prior to the closing of the exisiting property. Waiting until after the closing will be too late!
The QI is hired to prepare the exchange documentation and to hold the sale proceeds during the time between the sale of the existing property and the acquisition of the new property. The law requires the proceeds from the sale of the existing property be kept from the control of your client until a suitable replacement property is identified and ultimately transferred to the client by the QI.
HOW SHOULD MY CLIENT SELECT A QI?
Your client should select their QI based on its expertise, experience, integrity, and years in the exchange business. Starker Services, Inc. (“SSI”) is the nation’s largest and oldest independantly owned Qualified Intermediary. SSI facilitates thousands of exchanges each year and has been doing so for almost two decades!
HOW ARE MY CLIENT’S EXCHANGE FUNDS PROTECTED?
With longevity comes stability. SSI offers its clients almost two decades of exchange accommodation experience. In addition, SSI maintains a $5,000,000 fidelity bond to protect its clients from loss. Each exchange account is segregated which adds another layer of security making SSI one of the safest QI’s in the nation.
AFTER THEY’VE CHOSEN A QI, THEN WHAT?
Upon closing the sale of the relinquished property, your client must adhere to two timetables which both begin on the date the existing property is transferred. First, they must identify in writing possible replacement properties within 45 days of the closing. The QI will provide them with a form on which they may list up to three potential replacement properties of any value.
Once they have completed the ID form, they must fax or mail it to the QI by midnight on the 45th day.
Second, your client must acquire at least one of the identified properties prior to the expiration of the 180 day replacement period. Again, this period begins on day the relinquished property was transferred. Your client may buy more than one of the identified properties provided they all close before within the 180 day period.
The inability to acquire any of the identified properties will cause an exchange to fail. There is no mechanism for alternative property selection once the 45 day identification period has elapsed.
CAN MY CLIENT TAKE SOME CASH OUT WHILE STILL DOING AN EXCHANGE?
Yes. Any cash received will be subject to capital gains tax. Your client may take cash out at the closing of the sale property or upon completion of the exchange. Since they will be taxed on any proceeds being removed from the exchange, it will also be necessary to determine what their capital gain would be had they simply sold their property. This is because if they take cash out equal to or more than their capital gain, then they will be paying all the tax owed. An exchange at this point would be a useless exercise.
A Publication of Starker Services, Inc.
Clients considering the sale of investment or income property should first consult their financial or tax advisor to determine if a tax deferred exchange will benefit their long-term investment goals and retirement plans. Ultimately, your client must decide whether to take advantage of an IRC Section 1031 exchange or write a check to the IRS.
For more information call toll-free: (800) 332-1031. We will forward to you at no charge our informative Tax Deferred Exchanges brochure.
This material is provided for informational purposes only and is not to be construed as tax advice. The reader is strongly advised to speak with a tax consultant before attempting to employ any of the concepts stated herein.