1031 Exchange Made simple
How to defer capital gain tax
when selling a property in California
Many of you have probably heard about the IRS Section 1031 commonly known as “1031 Exchange” which allows to defer capital gain tax when selling a property used for business or investment purposes and purchase a “like-kind” property. Here are the four things you need to know if you are contemplating a 1031 exchange.
The Net Price
In order to defer all capital gain, your net purchase price must be greater than your net sales price. As an example, a property sold for $800K may have a net sales price of $750K after commissions and other qualified closing costs. A purchase of at least $750K is required to defer all capital gain tax. If you buy a property of lower value than you sold, you will be liable for taxes on the difference (this is known as “boot”). In addition, all the equity (proceeds) must be used towards the replacement property. Any proceeds left over after the exchange is completed are also known as boot.
The Like-Kind Property
Any real estate is considered to be like-kind with another real estate as long as both the properties sold and purchased are used for investment or business purposes. A primary residence or a second home cannot be used in a 1031 Exchange. Property purchased for resale, such as “flipped” homes also do not qualify for 1031 Exchange. Single-family rental homes, condos, commercial property, farm land, bare land held for business or investment purposes, located in the United States, are like-kind and can be exchanged. You can also buy and sell multiple properties within one exchange.
From the date escrow closes, there are two statutory deadlines. You have 45 calendar days to identify the property you are going to purchase and 180 calendar days to close on your replacement property. There are no extensions for weekends or holidays. If the 45th or 180th day falls on a Sunday, it still remains your deadline. When identifying a property, you can use either the Three Property Rule (i.e. identify up to 3 properties regardless of their value) or the 200% Rule (i.e. identify as many properties as you want up to an aggregate fair market value of 2 times what you sold).
In a 1031 Exchange, you must use a Qualified Intermediary (“QI”), also known as the Accommodator or Facilitator. The QI must be assigned into the contract on the property you are selling before escrow closes. Once escrow closes, the QI will hold the proceeds from the sale of the property. These proceeds are restricted for certain periods. You may withdraw proceeds before funds are sent to the QI, but withdrawals will be taxable boot.
Feel free to contact me if you have more questions about this increasingly popular way of swapping your assets at a reduced tax rate.