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Real estate in residence: 1031 exchanges can be tic tac dough

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Beth Bloch Beth Bloch
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Beth Bloch resides in Charleston and is a licensed real estate agent and consultant. She is an associate within the offices of Margo Teeter, Old Colony Realtors. She can be reached at reinresidence@gmail.com.

It is ironic that I have just successfully completed a 1031 tax-deferred exchange, considering April is "that" season. Tax season — it affects us all. 

If you have participated in a real estate transaction and subsequent filing of the IRS 1099-S, you are aware of the reality that taxes can eliminate well-earned profit. If you are thinking of selling a real estate investment in the coming year, be it big or small, your pocketbook might benefit from learning about my recent 1031 experience. Don't be the fool by not looking at the possibilities of a 1031 exchange and finding out if it might be applicable to your real estate transaction. 

Allowed tax deferral

Also known as a Starker Tax-Deferred Exchange (named for an investor who challenged and won a case against the IRS), Section 1031 of the United States Internal Revenue Code (26 U.S.C. 1031) explains "that the exchange of certain types of property may defer the recognition of capital gains or losses due upon a sale, and hence defer any capital gains taxes otherwise due." 

This long-time tool used by both taxpayers and investors is gaining renewed popularity because of the heated tax climate and changes affecting commerce. Most importantly, take advantage if you can; it is one of the only remaining tax deferral instruments allowed by the IRS. As I did, ask an accountant, lawyer or financial adviser if this exchange might work for you before you start the transaction. 

An office building, rental apartments and houses, or property held for investment are some of many examples of qualifying properties under the 1031. Much like the tic tac toe game of making moves within a structured form to win, 1031 exchanges allow you to move your real estate investment position tax deferred if it is structured correctly — a win for you on your taxes! 

Like-kind properties

If you are selling a qualifying property, as a taxpayer, you may reinvest your proceeds, tax deferred, into one or many other "like-kind" properties. Like-kind property is defined as property of the same nature, class or character, although quality and grade does not matter. Realizing that most real estate will be like-kind to other real estate, this gives an excellent opportunity to re-arrange your property investment dollars. Keep in mind the properties exchanged must be held for "productive use in a trade or business or for investment," your replacement properties must be equal to or greater than your net sale, and equal to your debt in the relinquished property to recognize 100 percent tax deferral, but it does not have to be. 

For example, if you are realizing the sale of a $500,000 parcel of land with a basis price of $200,000 and would like to defer the gains and the recapture depreciation taxes you will owe on the $300,000, you may do so by buying a like-kind property. Choosing to purchase a tenant-occupied apartment complex for $400,000 will offset $200,000 in capital gains exposure — therefore, only requiring you to pay taxes on $100,000. 

This is classified as a partial exchange. Or, you might take the same proceeds and purchase a tenant-occupied office building for $250,000, a high occupancy rental history four-unit apartment building for $150,000 and a small rental house in a great location for $100,000, using all of your proceeds, eliminating all tax liability. 

Hopefully, your new investments will be more profitable with greater possibility for appreciation. If you decide you do not want to be a landlord, or you are not interested in more property for management and are ready to see the many years of investing pay you back a little, you may be able to enjoy the sunshine of a beach house or condo if you meet the strict guidelines of purchasing a second or vacation home within the 1031 exchange. If you plan to rent for recreational purposes and keep your visits within a certain percentage of days leased, you might be a candidate.

Do your homework

To elect the 1031 recognition, a taxpayer must identify the "relinquished" property for exchange before closing, identify the "replacement" properties within 45 days of closing, and acquire the replacement properties within 180 days of closing. A qualified intermediary must be used to facilitate all transactions, by holding all the profits from the relinquished sale, then disbursing those monies at the replacement property closings. Start the qualified intermediary process early; the success of your exchange depends on it. You will need a qualified intermediary when you have a signed contract on the property you are selling. 

When you sell your relinquished property, it is very important that you do not touch any of the "boot," or monies, from the transaction. If you are in possession of any of the money, it will trigger taxes and possibly jeopardize the entire exchange. This is where the qualified intermediary comes in. He or she will handle all proceeds received from the sale of your relinquished property, wired to him or her at closing. Wiring your monies to someone you do not know is scary, so be sure to use a licensed Q.I. I did a lot of research on many qualified intermediaries and their services before making this decision. 

A few important things to consider when choosing your qualified intermediary: how many years have they been administering exchanges and the number of exchanges they have administered, of course, more exchanges, more experience and less likely for misappropriations or error. Use a tenured company. Do they hold a fidelity bond? Choose a company that does, and one that also carries errors and omission insurance. The Federation of Exchange Accommodators is a good source for information on qualified intermediaries. You will work with this company and individual for the entire exchange — the QI holds the money until you close on the replacement properties, no later than 180 days after sale. If you do not close on the replacement properties, the monies are returned to the taxpayer in entirety. If you do not meet your 45 - day identification period, your monies will be returned to you immediately. 

Lessons to learn

My 1031 experience was good — replacing the sold property with three new properties, all that better my position in the market, and avoiding a significant tax bill. Completing the exchange was hard work. There are many moving parts to the multiple transactions and many variables to consider. Something of importance is to be prudent in the process of negotiating for replacement properties. As the purchaser, or exchanger, if possible, it is smart not to disclose to the seller, or realtor, that the property you are submitting a contract for will be used as a 1031 replacement property until right before closing, or at least after the contract has been signed and accepted by the seller. It could put you at a disadvantage if the seller thinks their property is "needed" to offset your taxes, and might play hardball with the negotiations. They will, however, have to be able to work within your timeline so you may meet your deadlines and will be asked to acknowledge the sale by signing a disclosure stating that their property was involved in a 1031 exchange. 

To protect yourself, specify closing dates on the replacement properties to occur many weeks before your 180-day deadline. Believe me, you have to allow for interruptions, problems, delays and issues. Costs of the identified properties must not exceed 200 percent of your net sales proceeds. Choose and eliminate properties wisely. You may only purchase properties that have been identified to your qualified intermediary within the 45-day period. The industry leaders cite exchangers not being able to identify properties within in the 45-day identification period as the greatest reason for 1031 failure. You may identify properties that are not in contract yet. Choose properties that position you better in the real estate market and use the tax savings as interest free loan from the IRS to build your investment property portfolio. 

If you choose to do a 1031, be smart about the replacement choices, it often is not worth the tax savings if the new investments are losers. And remember, the taxes are deferred, not eliminated. When I sell my replacement properties, I will have to pay the taxes, or complete another 1031, purchasing more property to offset the gains. There is a lot to consider, so make your moves wisely, and be sure to explore your 1031 opportunities thoroughly before next April rolls around.