Northern Virginia Title & Escrow, Inc.

What is a 1031 Exchange?

Internal Revenue Code section 1031 allows you as a taxpayer to defer capital gain taxes that are due when you sell an investment property that has increased in value or has been depreciated for tax purposes. 1031 exchanges, also known as Starker Exchanges, are specifically structured transactions that join together the sale of an old investment property and the purchase of a new property for the purpose of deferring taxes.

An example would be where you purchased an investment property in 1990 for $75,000, and sell it in 2005 for $375,000, realizing a capital gain of $300,000 (provided you have no other capital expenditures you are eligible to write off, but let's keep it simple for now). Normally, you would have to pay capital gains tax on that $300,000, but with an IRS 1031 exchange you can defer paying capital gain's tax indefinitely provided you purchase a replacement property at a cost equal to or greater than the sale price of your sale.

Requirements

The property must be exchanged for property of Like Kind. All real property is considered like kind. So, although you are selling a single family home, you may purchase another single family home, condominium, townhouse, farm, vacant lot, or any combination thereof, so long as it is for investment purposes and is equal to or greater in cost than the sale property.

The taxpayer needs a "safe harbor" to store the exchange proceeds. The most commonly used safe harbor requires the services of a "Qualified Intermediary." The exchanger and the QI enter into an exchange agreement whereby the QI receives the proceeds of the exchanger's sale and deposits them into an escrow account. While the proceeds are held by the QI, the exchanger may not "receive, pledge, borrow or otherwise obtain the benefits of the money held by the QI." 26 CFR section 1.1031(k)-1(g).

The exchanger must identify replacement property to the QI within 45 days after the closing on their sale. This identification must be in writing, signed, dated, and delivered to the QI within the 45 day period. A fax is sufficient. The exchanger may identify up to 3 potential replacement properties without regard to the fair market value or may identify any number of properties as long as the sum of the fair market values does not exceed 200% of the fair market value of the relinquished properties. A ratified contract or acquisition of replacement property within the 45 day identification period is deemed identification.

The exchanger must close on the purchase of the replacement property within 180 days from the date of the sale closing, or the due date of exchanger's tax return, whichever is earlier. If a replacement property is not purchased within this period, the taxpayer will need to pay the capital gains tax that year on the sale.

NVT&E offers experienced and professional Qualified Intermediary services at very reasonable rates. If you are considering the sale of an investment property, feel free to call Douglas E. Wade, Esquire, at NVT&E.

 

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