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Tax-Deferred Exchanges

Are you considering selling real estate but concerned about paying capital gains on the sale? If so, you may want to consider utilizing a tax-deferred exchange under Section 1031 of the Internal Revenue code. 

A tax-deferred exchange is a method by which a property owner trades or exchanges one or more properties (“relinquished property”) for one or more other properties (“replacement property”). If the exchange of properties qualifies under Section 1031, capital gains tax that would have been paid on the sale of the relinquished property is deferred until such time as the replacement property is sold. In some limited circumstances, the deferral of tax may become permanent, eliminating tax liability altogether.

For an exchange to qualify under Section 1031, several rules must be followed:

The Purpose Requirement.  Both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale or held for personal use does not quality for a tax-deferred exchange.

The “Like Kind” Requirement.  The replacement property must be “like kind” to the relinquished property. “Like kind” refers to the nature of the property and not its grade or quality. Real property is like kind with other real property but not with personal property. For example, a property owner may exchange a tract of farmland for rental property but not for equipment.

Exchange Requirement.  Real estate must be exchanged for other property and not sold for cash. The most common type of exchange is the deferred exchange. In a deferred exchange, a qualified intermediary holds the proceeds of the sale of the relinquished property for use in acquiring the replacement property.  The taxpayer has 45 days from closing to identify its replacement property, and the replacement property must be acquired within 180 days of closing. These deadlines must be adhered to or the transaction will fail to qualify and tax will be owed on the sale of the relinquished property.

A tax-deferred exchange can be a valuable tool for property owners wishing to dispose of investment or business property. However, advanced planning is critical to the success of a tax-deferred exchange and should be undertaken prior to entering into a contract of sale on the relinquished property.