Tax Offset benefits – Real Estate Professionals – REPS
December 11, 2024
Tax – DST (Delaware Statutory Trust)
December 25, 2024The information provided herein is for informational purposes only and should not be relied upon as legal or regulatory advice. For accurate and comprehensive details, please consult a qualified professional or contact the appropriate government organization to obtain official guidance on the process.
1) Eligibility
Section 1031 allows U.S. taxpayers including individuals, entities, and foreign companies, to defer taxes on real estate sales used for business or investment. Key requirements include meeting the "same taxpayer" rule, where the seller and buyer share the same tax identity, and reinvesting proceeds in like-kind properties. Delaware Statutory Trusts (DSTs) provide an option for fractional ownership in high-value properties, enabling tax deferral when exchange rules are followed.
2) Exchange process
A simple sale followed by a purchase does not qualify as a 1031 Exchange. Under Section 1031 of the Internal Revenue Code, tax deferral applies only to exchanges of like-kind properties held for business or investment purposes.
The transaction must be structured as an exchange, often facilitated by a qualified intermediary (QI). The QI connects the sale to a buyer and the purchase from a seller, ensuring compliance. Importantly, the QI must be engaged before closing the initial sale (forward exchange) or purchase (reverse exchange).
A Qualified Intermediary (QI) is responsible for processing all the funds and transactions in a 1031 exchange to ensure it meets IRS guidelines
- Holding funds: The QI holds the proceeds from the sale of the relinquished property in a separate escrow account.
- Forwarding funds: When it's time to close on the replacement property, the QI forwards the funds to the seller.
- Preparing documentation: The QI helps prepare the necessary tax and legal paperwork.
- Coordinating: The QI coordinates with the involved parties.
- Ensuring compliance: The QI ensures that the exchange meets all the necessary conditions for deferring capital gains tax.
Held for Business or Investment Purposes
- To qualify for a 1031 Exchange, both the relinquished and replacement properties must be held for business or investment purposes.
- Personal-use properties, like primary residences, do not qualify
- The key is that the property must be used for trade, business, or investment purposes, regardless of its form or type.
Eligible Like kind Properties
The like-kind exchange rules empower investors to diversify or consolidate portfolios while deferring taxes. By understanding eligible properties and geographic rules, investors can effectively utilize 1031 exchanges to enhance their real estate strategy.
The following property types can be exchanged under the like-kind rules.
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Commercial properties
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Rentals (single-family, multi-family, vacation)
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Vacant lots
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Farm and ranchland
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Improvements not owned
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Mineral interests, water rights, easements
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Conservation easements
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Delaware Statutory Trusts (DSTs)
The type, location (domestic), or grade of the real estate does not matter, as long as the property is not personal so all below are considered "like kind", meaning sale of a vacant lot investment can be exchanged with a single family rental investment as well.
Value
This explanation outlines the basic requirements for deferring taxable gains in a 1031 exchange. To summarize the key points:
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Reinvestment of Equity: The property owner must reinvest all equity from the sale of the relinquished property into the replacement property.
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Replacement Property Value: The purchase price of the new property must be equal to or greater than the sale price of the relinquished property.
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Debt Requirements: Debt on the replacement property should be equal to or greater than the debt paid off on the relinquished property, ensuring "no net debt relief." This means that any reduction in debt or cash not reinvested (referred to as "boot") could be subject to taxation.
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Boot and Taxable Amounts: If the taxpayer opts to take cash out or reduces debt, the portion not reinvested becomes taxable.
Time Limit ( from day of sale of relinquished property)
- First 45 days :-
- Cannot terminate the exchange till the 45 days are over
- Can change the identified properties within the 45 days period
- Between 46th - 180th day :-
- If no property/ies were identified in first 45 days then
- Exchange can be closed, and funds disbursed to taxpayer with relevant capital gains and depreciation recapture due.
- if yes property/ies were identified in the first 45 days then
- The funds must remain held by the 'QI' until the transaction is completed or the 180-day exchange period ends.
- Identified property cannot be changed after 45th day
- Exchange funds cannot be released to the taxpayer until all the eligible identified properties have been purchased or the 180-day exchange period has expired.
- After 180 days :-
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- If ALL of the eligible properties on the identification list have been purchased, any excess funds will be released to you.
- If you have cash left over, or have not purchased replacement property at the end of the 180 day exchange period, your funds will be released to you.
Identification & Replacement Property Rules
The Identification & Replacement Property Rules under tax-deferred exchanges, such as those governed by Section 1031 of the IRS Code, revolve around three key provisions: the 3-Property Rule, the 200% Rule, and the 95% Rule. These rules are designed to provide flexibility while maintaining the integrity of the exchange process. Below is a breakdown:
THIS RULE LIMITS THE NO OF PROPERTIES
3-PROPERTY RULE
- Allows the taxpayer to identify up to three potential replacement properties, regardless of their total value.
- After the relinquished property is sold, the taxpayer can acquire one, two, or all three of the identified properties
THIS RULE LIMITS THE NO OF PROPERTIES
200% OF VALUE RULE
- Provides an alternative if more than three replacement properties are identified.
- The total combined fair market value (FMV) of all identified properties must not exceed 200% of the relinquished property’s value.
- The listing price is commonly used as a proxy for FMV to simplify calculations.
THIS RULE LIMITS THE NO OF PROPERTIES
95% OF IDENTIFIED RULE
- Rule may be offered when more than three properties and the FMV exceeds 200% of relinquished property’s value.
- To meet the requirements, the taxpayer must acquire at least 95% of the total FMV of the identified properties through the exchange.
Types of Exchanges
Each type of 1031 exchange offers unique advantages, allowing investors to tailor their strategy to their specific needs and circumstances.
Forward / Deferred Exchange
- The investor sells their relinquished property first.
- A Qualified Intermediary (QI) holds the sale proceeds
- The investor has 45 days to identify potential replacement properties
- The exchange must be completed within 180 days of selling the relinquished property
Reverse / Parking Exchange
- The replacement property is purchased before selling their relinquished property.
- An Exchange Accommodation Titleholder (EAT) first takes title of the replacement property not the taxpayer
- The replacement property is usually in a Sole member LLC owned by the 'EAT'
- The taxpayer sells the relinquished property within 180 days from purchase date of new replacement property
Build-to-Suit / Improvement Exchange
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Inclusion of improvement costs in the exchange value before taxpayer takes title to the property and within the 180 days period
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Covered Improvements : New construction, Renovations to existing structures, major upgrades such as new HVAC systems, roofing, or plumbing, substantial (not routine/minor) re-modeling or expansion of buildings
Investment time-frame
While there is no specific two-year rule in the IRS Code regarding how long you must hold a property after a 1031 exchange. However, the IRS requires that the replacement property be acquired with the intent to hold for investment or business purposes
The IRS generally considers properties held for at least two years as sufficient evidence of an investment intent for a 1031 exchange. This is especially relevant under the "safe harbor" provisions outlined in IRS guidance
Qualified Intermediary Fees
- Basic 1031 Exchange (Simple Transaction): $800 to $1,200. Add around $300 to $500 per additional property.
- Complex or Reverse Exchanges: $3,000 to $7,500. Add around $1500 to $2500 per additional property.
Reporting to IRS
- The final step takes place when you file your taxes for the year in which the exchange occurred. You are required to report the exchange to the IRS using Form 8824. Along with your final statement, the QI may provide a workbook to guide you through completing Form 8824 accurately.
Conclusion
This tax deferment strategy essentially supercharges your investment potential. By postponing the payment of capital gains taxes and depreciation recapture, you're able to reinvest a larger sum of money - including the amount you would have paid in taxes. This increased capital gives you significantly more buying power in the real estate market.
Moreover, you're not just using this deferred tax money - you're growing it. The funds that would have gone to the IRS are instead working for you, appreciating in value as part of your new, likely larger, real estate investment. This creates a compounding effect, where you're potentially earning returns on money that would otherwise have been paid out in taxes.
In essence, you're leveraging the government's money (the deferred taxes) to fuel your own investment growth, creating an opportunity for accelerated wealth accumulation in real estate.
Safe harbour rules by IRS
- Ensure QI processes the transaction
- Ensure timelines and one of the three types of exhange method is followed
- Must be owned for at least 24 months before the exchange[5].
- Rented for at least 14 days in each of the two 12-month periods preceding the sale[5].
- Personal use limited to 14 days or 10% of rental days, whichever is greater[5].
More on variations of 1031 exchange
