I mainly work with Internet buyers and many of them are looking to invest in the Charleston, S.C. and Folly Beach areas. I have solid experience in dealing with clients seeking to buy second homes for vacation and rental income use.
If you are seeking additional information on how to initiate an exchange, the "do’s" and "don’ts" of 1031s, 1031 terminology… I suggest you view the following publication which will give you an overview of the 1031 tax deferred process: http://www.ipx1031.com/pdf/IPX1031BriefExchanges.pdf
The above resource link/document represents just a small amount of the information available to you. I recommend you read some of the pages below and consult a qualified attorney and tax adviser to validate your decisions.
I can also be reached at (843) 345-6074 or via email.
Thanks to IRC #1031, a properly structured exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC #1031 (a)(1) states:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."
To understand the powerful protection an exchange offers,
consider the following example:
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An investor has a $200,000 capital gain and incurs a tax liability of approximately $50,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold.
Only $130,000 remains to reinvest in another property. Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property. |
As the above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the IRC. For instance, an accurate understanding of the key term "like-kind" – often mistakenly thought to mean the same exact types of property – can reveal possibilities that might have been dismissed or overlooked. API is your resource to obtain accurate and thorough information about the entire exchange process.
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The Opportunity Exists For Successful Vacation/Second Home #1031 Exchanges
Property owners throughout the nation are obtaining the benefit of full reinvestment of equity under Internal Revenue Code #1031. Many investors exchange out of a single family rental, duplex, or any other type of investment property and into a vacation/second home. Many tax/legal advisors believe it is possible to perform an exchange on a vacation property which has no rental history but which still can be considered "held for investment."
Support For Vacation Home Exchanges?
Private Letter Ruling (PLR) 8103117, the IRS did allow for tax deferral when a property owner intended to acquire property for personal enjoyment and as an investment. As stated in this PLR, "…the house and lot you acquire in this trade will be held for the same purposes as the properties exchanged: to provide for personal enjoyment and to make a sound real estate investment." Although a PLR only applies to the facts and circumstances in a particular individual�s specific situation, it appears, in this instance, that "personal enjoyment" of a property does not prevent a property owner from benefiting from a tax deferred exchange.
Property owners throughout the nation are obtaining the benefit of full reinvestment of equity under Internal Revenue Code #1031. Many investors exchange out of a single family rental, duplex, or any other type of investment property and into a vacation/second home. Many tax/legal advisors believe it is possible to perform an exchange on a vacation property which has no rental history but which still can be considered "held for investment."
Each Individual Case Must Be Reviewed
Note: There are no regulations, statutes, or court cases which give a definitive answer on the exchange of vacation/2nd homes. Each exchange must be reviewed on a case-by-case basis. To qualify for an exchange, the property owner should be able to support that the property was "held for investment."
A BRIEF ANALYSIS
IRC Section 1031 provides for the non-recognition of gain on the exchange of property "held for productive use in a trade or business or for investment." Is a vacation property considered "held for investment?"
Reg. 1.1031(a)-1(b) states in the definition of "like-kind" that "unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale." It appears that even property owners who have never rented their vacation property but can substantiate that they acquired and held the property because they expected it to increase in value (a wise investment decision) may qualify for a #1031 tax deferred exchange. IRC ?165 and IRC ?280, which address when losses may be deducted on vacation homes, may provide additional guidance to investors.
It is a well known fact that many vacation areas have appreciated significantly in recent years and that often property owners purchase properties with the future appreciation in mind. A real estate investor should consult with their own advisors to discuss their specific situation and see if they may qualify for the benefits of a tax deferred exchange.
Information Provided by
Asset Preservation, Inc.
National Headquarters: 800-282-1031 or info@apiexchange.com
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
� 2000 Asset Preservation, Inc.
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The real power of a tax deferred exchange is not just the tax savings – it is the tremendous increase in purchasing power generated by this tax savings!
With the advantages of leverage, every dollar saved in taxes allows a real estate investor to purchase two to three times more real estate. Many investors are surprised to discover that capital gain taxes are far higher than 15%. State taxes, which can be as high as 11% in some states, are added to the federal capital gain tax owed. In addition, depreciation deducted over the ownership period is taxed at a rate of 25%. The net result is often a large percentage of your profits going directly to pay taxes. Under the 4th calculation, the net equity times four (assuming a 25% down payment) is the value of property you could purchase after paying all capital gain taxes.
Under the 5th calculation involving an exchange, no taxes are paid, leaving the full purchasing power of the ENTIRE GROSS EQUITY to acquire considerably more real estate! In just one transaction, the Exchanger acquires far more investment property than a seller!
Note: Asset Preservation, Inc. cannot give tax and or legal advice. Every taxpayer should review their specific transaction and potential tax consequences with their own tax and/or legal advisors.
Compare the tax savings of an exchange vs. a taxable sale
| 1 | Calculate Net Adjusted Basis | Original Purchase Price + Improvements – Depreciation = Net Adjusted Basis |
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| 2 | Calculate Capital Gain | Sales Price – Net Adjusted Basis – Cost of Sale = Capital Gain |
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| 3 | Calculate Capital Gain Tax Due | Recaptured Deprection (25% ) + Federal Capital Gain (15%) + State Tax (when applicable) = Total Tax Due |
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| 4 | Analyze purchase – No exchange | – Cost of Sale – Loan Balances = Gross Equity – Capital Gain Taxes Due = Net Equity Net Equity X 4 = |
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| 5 | Analyze purchase – exchange | Capital Gain Taxes Due Gross Equity = Net Equity Gross Equity x 4 = |
0 |
Information Provided by
Asset Preservation, Inc.
National Headquarters: 800-282-1031 or info@apiexchange.com
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
� 2000 Asset Preservation, Inc.
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Section 1031 tax deferred exchanges continue to increase in popularity as more investors nationwide discover the wide range of investment objectives that can be easily met through exchanging.
I. Preservation of Equity
A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal and State capital gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash! Most often, the capital gain taxes are deferred indefinately because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange!
II. Leverage
Many investors exchange from a property where they have a high equity position or one that is "free and clear" into a much more valuable property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increase an investors return on their investment.
III. Diversification
Exchangers have a number of opportunities for diversification through exchanges. One option is to diversify into another geographic region such as exchanging of one apartment builidng in Denver, Colorado for two additional apartments � one in Los Angeles, California and the other in Dallas, Texas. Another diversification alternative is acquiring a different property type such as exchanging from several residential units to a small retail strip center.
IV. Management Relief
Many investors accumulate several single family rentals over the years. The on-going maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintance and management. Exchanging into a single apartment complex with a resident manager is a good example of this strategy.
V. Estate Planing
Often a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property which they can either hold or sell. Call the knowledgable exchange professionals at Asset Preservation for a complimentary consultation regarding your specific investment objectives.
Information Provided by
Asset Preservation, Inc.
National Headquarters: 800-282-1031 or info@apiexchange.com
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
� 2000 Asset Preservation, Inc.
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Identification Rules
"It’s esential to adhere to these requirements"
The identification period in a delayed exchange begins on the date the Exchanger transfers the relinquished property and ends at midnight on the 45th calendar day thereafter. To qualify for a 1031 tax deferred exchange, the tax code requires identifying replacement property:
- In a written document signed by the Exchanger
- Hand delivered, mailed, telecopied, or otherwise sent
- Before the end of the identification period to
- Either the person obligated to transfer the replacement property to the Exchanger [generally the "Qualified Intermediary"] or any other person involved in the exchange other than the taxpayer or a disqualified person.
The replacement property must be unambiguously described (i.e. legal description, street address or distinquishable name). The type of property should be described in a personal property exchange.
Additional Issues
Exchangers acquiring a property which is being constructed must identify this property and the improvements in as much detail as is practical at the time the identification is made. Exchangers who intend to acquire less than a 100% ownership interest in the replacement property should specify the specific percentage interest. Exchangers should always consult with their tax and/or legal advisors about the specific identification rules and restrictions.
Any properties acquired within the 45-day identification period are considered properly identified. An investor has the ability to substitute new replacement properties by revoking a previous identification and correctly identifying new replacement properties as long as this is done in writing within the 45-day identification period. Although Exchangers can identify more than one replacement property, the maximum number of properties that can be identified is limited to:
A. Three properties without regard to their fair market value ("3 Property Rule")
B. Any number of properties so long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all relinquished properties ("200% Rule")
C. Any number of properties without regard to the combined fair market value, as long the properties acquired amount to at least ninety five percent of the fair market value of all identified properties ("95% Exception").
Information Provided by
Asset Preservation, Inc.
National Headquarters: 800-282-1031 or info@apiexchange.com
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
� 2000 Asset Preservation, Inc.
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"New Reverse Exchange Safe Harbor Finalized
A reverse exchange occurs when the replacement (purchase) property is acquired prior to closing on the relinquished (sale) property. Exchangers nationwide can now confidently proceed with a "reverse exchange" that adheres to the Revenue Procedure 2000-37 released on September 15, 2000. The new safe harbor offers welcome clarification and will make the reverse a more popular and accepted exchange variation!
Highlights of the Reverse Guidelines
- The Accommodation Titleholder, through a "qualified exchange accommodation arrangement" (QEAA), may hold title to either the relinquished or replacement property
- The Exchanger must have the requisite intent that the purchase of the replacement property be part of an exchange.
- Within 45 days of purchasing the replacement property, the Exchanger must "identify" (subject to the rules in the ?1031 tax code) the relinquished property to be sold in the exchange.
- The reverse exchange must be completed within 180 calendar days.
The Exchanger may loan or advance funds to the Intermediary for the purchase of the replacement property. - The Exchanger may supervises improvements, act as a contractor or assume other management functions.
Additional Issues
- If financing is involved, the lender should be consulted since the Intermediary must hold title to property.
- The Exchanger may enter into a lease or management agreement with the Intermediary.
- The reverse exchange may be combined with an "Improvement Exchange" to allow for additional construction improvements. However, the 180-day time limit will apply.
- Reverse exchanges utilizing a "parking arrangement" outside this procedure may still be able to qualify for tax deferral.
- It is critical to thoroughly scrutinize the way (such as a separate LLC for each Exchanger) the Intermediary holds title to property.
Information Provided by
Asset Preservation, Inc.
National Headquarters: 800-282-1031 or info@apiexchange.com
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
� 2000 Asset Preservation, Inc.
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Reinvest all exchange proceeds
If an Exchanger does not reinvest all exchange proceeds from the sale of the relinquished property, the balance received is considered "cash boot", and gain may be recognized on that amount.
Acquire property with the same or greather debt
If an Exchanger does not acquire a replacement property with an equal or greater amount of debt, he or she is relieved of a debt obligation, which is considered "mortgage boot". The IRS considers this reduction in debt a benefit to the Exchanger; therefore, it is taxable, unless it is offset by adding equivalent cash to the replacement property purchase.
How it works
| Example I | Sale | Purchase | Boot | ||||
| Sale price | $ 450,000 | Purchase price | $ 600,000 | ||||
| – Debt | – $ 200,000 | New Debt | $ 380,000 | 0 | |||
| – Cost of Sale | – $ 30,000 | ||||||
| Exchange Proceeds | = $ 220,000 | Down Payment | $ 220,000 | 0 | |||
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Analysis Since the Exchanger acquired $180,000 more debt and reinvested all the net ecquity, the tax is fully tax deffered. |
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| Example II | Sale | Purchase | Boot | ||||
| Sale price | $ 450,000 | Purchase price | $ 360,000 | ||||
| – Debt | – $ 200,000 | New Debt | $ 160,000 | $40,000 | |||
| – Cost of Sale | – $ 30,000 | ||||||
| Exchange Proceeds | = $ 220,000 | Down Payment | $ 200,000 | $20,000 | |||
| Total Boot | $60,000 | ||||||
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Analysis Since the Exchanger only acquired $160,000 of debt, there is $40,000 of mortgage boot. Additionaly, the Exchanger did not reinvest $20,000 of the net equility, which results in $20,000 of cash boot. The combined amounts ($40,000+$20,000) equate to $60,000 in boot, which is taxable. |
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Information Provided by
Asset Preservation, Inc.
National Headquarters: 800-282-1031 or info@apiexchange.com
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
� 2000 Asset Preservation, Inc.
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