As many investors in bigger cities like Los Angeles and Phoenix look to capitalize on the strong market by selling and looking to reinvest in small communities like Prescott (and who could blame them, we live in paradise), many are faced with the prospect of having to pay up to 1/3 of their appreciation in capital gains tax. Many look to the 1031 tax deferred exchange in order to defer taxes and keep their money working for them in the market. Yet, a 1031 tax deferred exchange is challenging, and somewhat complicated. Here’s some things you should know if this is the option you are considering to move your assets to Prescott, AZ.
Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.
The transactions (sale and purchase) under a 1031 tax deferred exchange must be highly structured to meet the IRS criteria for a 1031 Exchange. It is essential to have a 1031 Exchange Accommodator (also referred to as a 1031 Exchange Facilitator) to execute the necessary documents and ensure compliance with applicable laws, rulings and regulations.
It is important to know that your Facilitator must be assigned into the entire process (sales, agreements, contracts, escrow instructions), otherwise you will not qualify for 1031 tax deferred treatment.
What you sell must be replaced by one or more properties that are of equal or greater in net value (purchase) than the net value (sales) of the sold property (sold property referred to as “relinquished” property. All net cash proceeds from sale of relinquished property. Any debt that was paid off from the sale of the relinquished property must be replaced with an equal amount of debt on the replacement (like kind) property. If you pull any cash out of the transaction, you are subject to capital gains income tax and, or incur depreciation recapture.
Both the relinquished property and the replacement property (like kind) must be an investment or rental property.
So, what is “like kind” property? Basically, if you are trading one rental, or investment property, for another. Many think that if you owned a single family home, you must purchase a single family home. Not true. It must simply meet the requirement discussed briefly in the previous paragraph.
Additionally, you may consolidate properties and invest in more properties in exchanges as long as the properties meet the “like kind” requirements and the the net value of the relinquished property equals that of the replacement property. Example: You trade your 10 unit apartment condo for 3 townhouse rentals of equal value (as stated, the replacement property can be of equal or greater value).
There are also very specific 1031 deferred tax exchange timelines and identification requirements that must be followed. You have 45 calendar days to identify a replacement property after the relinquished property is sold. Then, you have 135 calendar days to close on the replacement property. In short, you have 180 days to complete the 1031 exchange.
There are a few other rules, but this is the bulk of what you should know. Most importantly, do not go forward with a 1031 tax deferred exchange without engaging a highly qualified realtor for the sales and purchase, your CPA who knows your cash and tax position well, and a qualified 1031 Exchange Facilitator. A small mistake in your process or paperwork could cost you well over six figures in taxes.
Contact Red Arrow Real Estate of Prescott, AZ. Red Arrow Real Estate is the largest independent real estate brokerage firm in the tri-cities area and has successfully represented clients since 1987.