Under the new tax laws, we are seeing a large influx of high income, high net worth individuals moving from high-tax states to low-tax states such as Arizona (ranked as one of several “Most Tax Friendly” according to Kiplinger). Relocating a primary residence is generally completed with little to no tax consequence (capital gain tax liability for a primary residence held over two years is tax-free for gains up to $250,000 for an individual, and $500,000 for married). Selling investment real estate is a little more complicated. Federal capital gains tax are 20% and an additional 3.8% Affordable Care Act (Obamacare Investment Income Tax). Then there are State Level Capital Gains Taxes. California-held investments are subject to state tax of 13.3% (Each state varies; Arizona is 4.9%). Finally, there is a tax of 25% on the “depreciation recapture.” Exhausted yet? Thankfully, the Internal Revenue Code (IRC) allows for real estate investments that are sold and reinvested where the investor can defer all capital gains taxes.
1031 Tax-Deferred Exchange:
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.”
Essentially, an investor is able to sell a property, and move sale proceeds into a new property or properties and defer all capital gains taxes. Leverage! One can direct sale proceeds from investment real estate for more valuable real estate, or increase cash flow or diversifying into other properties. Sadly, we have seen some folks not knowing the advantages of a tax-deferred exchange pay the capital gains taxes, which greatly diminishes their buying power for replacement property.
One of the biggest misconceptions of a 1031 exchange is the “like kind” rule. Example: A brother and sister inherit a land tract held by a parent that has been in the family for many years, which has substantial appreciation. They do not know what to do with the land and subsequently it is held for many years. They are approached by a broker to sell the land for a major profit. “Like Kind” in the eyes of many is “Land” for “Land” or “condo” for “condo” or “Mobile Home Park” for “Mobile Home Park.” This is not true. “Like Kind” is basically real estate for real estate. Stocks for Real Estate and vice versa is not “Like Kind.” A duplex can be exchanged for a single-family rental or vacant land can be exchanged for a shopping center, an office for apartments. Real estate for real estate. What is not like kind is a primary residence or second home. However, a second home or vacation home can become eligible if rented for at least 14 days each year over the previous two years.
BASIS 1031 RULES:
The net sales price of the replacement property must be equal to or greater than the sale of the “exchanged” or relinquished property.
All of the net proceeds from the relinquished property must be invested into the replacement property. Left-over or unused funds not placed into the exchange are subject to capital gains.
The investor cannot receive sale proceeds, rather, a “Qualified Intermediary” must be used to facilitate the exchange.
The replacement property must have equal or greater financing then what was paid off from the relinquished property. However, any debt can be offset with cash added to the exchange.
Title & Vesting generally must be held in the same name from relinquished to replacement property.
The replacement property must be identified with 45 days from the close of escrow of the sale of the relinquished property. The subsequent purchase must be made within 180 days of the sale of the relinquished property.
It is very easy to miss the mark on one of the many rules that affect the “tax deferral” on the sale and subsequent replacement purchase of a 1031 exchange. It is important to retain and have the best qualified advisors in effectively managing and overseeing your exchange.
1031 Exchange Qualified Real Estate Advisors:
Hire a competent Real Estate Broker that is familiar with, experienced in, and can effectively manage your real estate exchange. Your real estate advisors should be professional, with tenacious negotiation skills, experienced with property and rent evaluations and is responsive to your needs. QCBN
By Peter Medal
Peter Medal, Leslie Nelson and Andrea Mauk are the Prescott Elite Team at My Home Group Real Estate. Their offices are in downtown Prescott at 240 S. Montezuma Street, Suite 101. Reach them at 928-597-5151 PrescottEliteTeam.com or PrescottEliteTeam@gmail.com.