Real Estate

Tax Deferred Exchanges for Real Estate Investors

Investors often wonder whether any legal options exist for the avoidance of capital gains tax liability when investment properties are sold. Under the "Tax Deferred Exchange" or "1031Exchange" an investor sells property owned for income or investment purposes and then acquires replacement property also to be owned for income or investment purposes. Investors can essentially trade in one investment property for another, put all of their equity from the first property into the replacement property, and defer the payment of capital gains taxes.

1031 Exchanges most often occur in situations where the investor first disposes of his old property and then acquires a new property. The investor will assign the proceeds from the disposal of his old property (the "Relinquished Property") to a Qualified Intermediary ("QI") who holds it in a qualified escrow account. When the investor receives the title to the new property that the investor is acquiring (the "Replacement Property"), the QI will disburse the funds in escrow to the seller of the Replacement Property. This type of arrangement allows the taxpayer to avoid receiving any cash from the transactions which would immediately trigger capital gains tax liability.

1031 Exchanges require adherence to strict statutory requirements. First, the investor must purchase a "like kind" property. In the case of real estate, this means that the investor must purchase another piece of real estate. However, the Relinquished Property and the Replacement Properties can differ as to grade or quality. For example, if the Relinquished Property is residential real estate, the Replacement Property must also be real estate, but it can be a commercial building, unimproved land, or a multi-family rental property. Tax Deferred Exchanges have also been permitted for exchanges of different types of aircraft, buses, livestock of the same gender, and garbage routes. Tax Deferred Exchanges are not permitted for partnership interests, inventory, stocks, bonds, securities, or promissory notes.

In addition, strict time limits are set forth for the timeframe for identifying the Replacement Property, the settlement date of the Replacement Property and the price of the Replacement Property. The investor has forty five (45) days from the date the Relinquished Property closes to indentify a Replacement Property by sending written notice to the QI. The investor may identify more than one Replacement Property, but he may not change the list of identified Replacement Properties after the forty five (45) days has passed. If the investor does not purchase one of the Replacement Properties on his list, the exchange fails. In addition, the investor must close on the purchase of the Replacement Property within one hundred eighty (180) days after closing on the Relinquished Property. Finally, in order to avoid capital gains tax liability, the investor must purchase a Replacement Property that is equal to or of greater value than the Relinquished Property.

Pesner Kawamoto has substantial experience in counseling individuals and businesses who wish to engage in 1031 Exchanges, and will ensure that the rules and requirements are smoothly navigated. For more details about structuring a 1031 Exchange, please contact Susan Pesner or Christopher DeMers.