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The Largest IRS Loophole – Section 1031 Exchanges

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There are very few loopholes in the IRS Regulations that allow for significant tax savings so large, that they seem impossible. My readers are always asking for ways to reduce their taxes, but this month’s article goes way beyond that because it discusses a way to defer paying taxes for years, or perhaps in some instances, never.  If you are one of my readers who are real estate agents, brokers, and investors, this article is particularly for you!  If you are a business owner, you can use this technique as well.

The Basics
Section 1031 of the tax code allows taxpayers to enjoy a deferral from taxes if they relinquish business property in exchange for like-kind property. This is normally implemented for real estate transactions but is also available for vehicles, equipment, livestock and any other business property. However, you cannot apply this code section to any personal use property such as your residence or personal car or truck, and it also doesn’t apply to stocks, bonds or other investments.

The Rules

  • The new property must be equivalent or higher in value and it must be a like-kind property: real estate for real estate (it can be land for an apartment building), a car for a car (or a truck). In other words, you cannot exchange raw land for equipment or an apartment building for a vehicle. The IRS is stricter when it comes to animals: If you want to exchange livestock, it must be of the same sex or a like-kind exchange will not fly.
  • The business nature of the transaction must remain intact: You cannot trade a rental property for a personal residence even though they are like-kind in the sense that they are both classified as real estate. Also, you cannot exchange a property into one that is located outside of the United States.
  • If you are a dealer in real estate, such as a house flipper, you do not qualify for 1031 exchange deferral. It’s possible that you are both an investor and a dealer. If that’s the case, then the properties in which you have investment activities would qualify for 1031 exchange.
  • Beware – There is one significant thing for you to be aware of.  If you receive any cash in the deal, this is considered “boot” and is subject to capital gains taxes.
  • If the sale would result in a loss, a 1031 exchange is normally not your best choice. However, there are some instances in which it may prove beneficial. For example, if a loss will not benefit you tax-wise, you may want to defer the gain and enjoy an increase in basis of the new property. An increased basis results in a larger depreciation deduction.

How To Get It Done

For this example, we will assume you own a rental property that you can sell for a profit. Maybe the property in question is a duplex or a single family residence and you want to sell it and move up to an apartment building. The reason you are selling is not significant, the focus is on how the transaction is handled.

First, and very important – you cannot just sell the property and buy the new one. You must run the transaction through an accommodator or an attorney who specializes in these types of transactions.  The entire transaction depends on an independent third party handling the transaction.

Secondly, the code states that the property to be exchanged must be identified within 45 days, and received within 180 days. Make sure that you meet these requirements or the entire project can get blown out of the water!

Source: 8/22/13 Fox Buiness Authour Bonnie Lee


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