One of the most powerful options for tax deferral, when selling investment real estate, is the Section 1031 Exchange. Not only is it possible to indefinitely defer taxes due on property sold, but the tax code can also be used as a great estate planning tool.
Because heirs will receive a “step-up“ in cost basis (to the present market value) when the original owner dies, all taxes deferred by the exchange are forgiven. This present market value becomes the heir’s new cost basis in the property, and only the gain from this point on is considered taxable.
Exchangers should be aware that any guidelines must be followed to avoid invaliding their exchange, creating a taxable event. A lesser known rule involves an exchange beginning after October 15th of any calendar year. When an exchange begins after this date, the 180-day closing period crosses over into the new year and ends after “Tax Day”.
The example below demonstrates how an issue may arise if the seller filed and paid his 2019 taxes early in 2020, while still within the 180-day closing period, and prior to purchasing replacement property:
John Smith sold his investment property on November 27, 2019 and the funds were deposited into his qualified intermediary’s escrow account. John now has 45 CALENDAR days to identify his replacement property or properties. To complete a valid exchange, John must now purchase replacement property within his exchange period, ending 180 DAYS from November 27th.
Unaware, John pays his 2019 income taxes on February 7, 2020, prior to closing on his new property and before the end of his 180-day exchange period. Under the tax code he will have essentially “crashed” his exchange and will be taxed despite all efforts to defer.
The rules are quite clear that you must complete the exchange prior to paying the previous year’s income taxes. The other option is to file for an automatic extension of the April 15th filing deadline so you can take advantage of the full 180 day time period. This will prevent an invalid exchange should your exchange period end after Tax Day.
The best way to avoid this scenario is to make sure you have a team of qualified professionals to help you facilitate your exchange, including but not limited to:
A “QI” is an independent third party to the transaction whose function is to prepare the documents necessary to create the exchange, as well as to act as the independent escrow agent for the exchange funds. Your QI will essentially act as a stand-in for you during the exchange
Real Estate Attorneys understand existing regulations and can make sure you are compliant throughout your entire exchange process. Your Real Estate Attorney can consult you in every phase of your transaction and provide educational insight on any changing tax laws
Closing statements can include a lot of debits, credits and confusing facts unfamiliar to taxpayers. Your CPA can help you understand your tax prorations, security deposits and all other related transaction expenses. It is important to select your team BEFORE you sell your property to ensure proper planning prior to implementing your 1031 Exchange.