What are ‘similar’ exchanges and how do they affect capital gains taxes?

What is that Section 1031 exchange, also known as ‘similar’ exchange?

Currently, Section 1031 of our beloved Internal Revenue Code allows you to defer your federal income tax bill from dismantling appreciated estate by arranging for a Section exchange – AKA one similar form of exchange. This age-old volatility is a big reason why some real estate investors have grown rich over the years.

The previous version of Biden’s tax plan would severely limit your ability to defer taxes with the Section 1031 exchange. While that proposed tax increase is no longer viable now, it could return sooner rather than later. later if lawmakers are serious about trying to fix the federal budget deficit. So it might be a really good idea for Section 1031 exchanges to be made sooner rather than later while the current taxpayer-friendly rules still apply.

Section 1031 exchange tax basics

You can arrange to swap the real asset as long as the canceled asset (the asset you unload in the swap) and the replacement asset (the asset you receive in the swap) are of the same type. While that sounds like a potential problem, it’s not, because anything defined as a real property can be swapped for anything else defined as a property. real.

What constitutes real estate?

Good question. Thankfully, IRS regulations use a very broad brush to determine real property for Section 1031 exchange purposes. The starting point is real estate including land, improvements to land, uncovered natural products of the land, and the air and water spaces adjacent to the land.

If interconnected properties work together to serve a permanent structure (e.g. systems that provide electricity, heat, or water to a building), the property may qualify as a structural components of real assets. For example, a gas line that fuels a building’s heating system counts as real property.

The regulations also list examples of intangible assets that can be considered real assets – such as options, leases, movable properties and land development rights.

The regulations also provide that any property deemed real property under applicable state or local law is treated as real property for Section 1031 exchange purposes.

Finally, the regulations allow you to receive a “random” amount of personal property in a Section 1031 exchange. Random personal property can represent up to 15% of a person’s total fair market value. asset. For example, let’s say you are purchasing a small hotel for $30 million in a Section 1031 swap. The swap could include up to $4.5 million worth of personal property ( 15% of $30 million) and the entire package would be eligible for favorable Section 1031 processing.

Important point: Contact your tax advisor for full details of what constitutes an estate before activating what you hope will be a 100% tax-deferred Section 1031 exchange.

Impact of ‘boot’

To avoid any current taxable income on real estate swaps, you must avoid receiving any “backs.” Boot means cash and property not defined as real property. As far as collateral is concerned, the startup also includes an excess of the mortgage on the foreclosed property (the debt you write off) versus the mortgage on the replacement property (the debt you assume) .

If you receive footwear, you are currently taxed on an interest equal to the lesser of: (1) the value of the shoe or (2) your overall profit on the transaction based on market value. reasonable. So if you only get a starter amount, your swap will mostly still be tax-deferred (as opposed to completely tax-deferred). On the other hand, if you get a lot of donations, you can have a large taxable profit.

The easiest way to avoid getting any crashes is to swap a less valuable asset for a more valuable asset. That way, you’ll pay the startup rather than get it. Initiating a payment will not trigger a taxable income on your part of the transaction.

In any event, the untaxed gains in a Section 1031 swap will be carried over to the replacement, which will remain untaxed until you sell the replacement in a transaction. taxable.

Exchange Section 1031 deferred

As you can imagine, it is often difficult, if not impossible, for people who want to do a Section 1031 swap to find another party that owns a suitable replacement and who also want to do so. Swap Section 1031 rather than sell cash. The savings opportunity is that deferred exchanges may also qualify for the tax-deferred Section 1031 exchange preference.

Under the deferred exchange rule, you do not need to swap directly and immediately one asset for another. Instead, you can, in effect, sell the ceded property for cash, transfer the proceeds of the sale with a qualified middleman who effectively functions as your agent, locates then arrange for a similar tax-free exchange by brokering the purchase of the property on your behalf. This is how a typical deferred swap works.

* You transfer the surrendered asset (the property you want to swap) to one qualified intermediaries. The role of the middleman is simply to facilitate a Section 1031 exchange for a fee typically based on a sliding scale to the value of the transaction. In terms of percentages, the intermediary fees are generally quite reasonable.

* Next, the middleman arranges the sale of the property for your cash. The middleman will then hold the proceeds from the sale in cash on your behalf.

* The intermediary then uses the cash to purchase a suitable replacement property that you have identified and approved in advance.

*Finally, the intermediary transfers the surrogate assets to you to complete the Section 1031 exchange.

That’s it! In your view, this series of transactions counts as a tax-deferred Section 1031 swap. Why? Because you end up with alternative assets that have never actually seen the lubricating cash slip for the underlying transactions.

Important point: See the sidebar for basic requirements for making a deferred Section 1031 exchange.

Tax Savings Bonus

What if you still own the surrogate property when you die? Under our applicable federal income tax rules, any taxable income will be written off entirely thanks to another favorable provision that raises the tax base of a deceased person’s estate to fair market value before its death date. So, under current rules, taxable gains can be indefinitely deferred with similar swaps and then written off if you die while still in possession of the property. OH.

Your heirs can then sell the property and owe no federal income tax or just a small amount of tax based on the post-mortem appreciation, if applicable. It’s a deal. Real estate fortunes were made this way without having to be shared with Uncle Sam.

Warning: An earlier version of the Biden tax plan would significantly reduce the dead-day base break. While that proposed tax increase is no longer viable now, it could return sooner rather than later. If it does come back, we can expect that it will only affect the really wealthy. Crossed fingers.

Key point

While a Section 1031 exchange can get quite complicated, the tax benefits can be huge, which makes all the hassles worth it. As noted earlier, doing a Section 1031 exchange sooner rather than later may be advisable. Finally, get your tax advisor involved to avoid mistakes. The Item 1031 exchange arrangement is not a good DIY project IMHO.

Sidebar: Requirements for Deferred Section 1031 swaps

In order for your deferred real estate exchange to qualify for tax exemption under Section 1031 swaps, you must meet two important requirements.

1. You must clearly identify the replacement asset before the end of 45 days definite period. The period that begins when you transfer the canceled asset. You can satisfy the identification requirement by specifying the surrogate property in a written and signed document that is given to a middleman. In fact, that document can list up to three different properties that you would accept as a suitable replacement.

2. You must receive the replacement property before the end exchange time, which may not exceed 180 days. Like the identification phase, the exchange phase also begins when you transfer the forfeited asset. The exchange period ends on earlier of: (1) 180 days after the assignment or (2) the due date (including renewal) of your federal income tax return for the year including the date of the transfer. When your tax return due date reduces the exchange period to less than 180 days, you can simply extend your return. That restores the full 180-day period.