A.D. Cantelmo Property Management
Our Business is Property Management in Orange County California
Get rich and defer taxes
We all love the ability to make money and not pay any taxes
and anyone who denies that is either lying or they need some specialized help.
The problem is that so many people don’t know how to do it. I was talking to a
young family who just bought a home and they wanted some information on how to
get into the rental property business. We talked for a long time and in the end
of the conversation, I threw in a bonus. I explained how they could grow
their rental business and defer taxes by doing a 1031 exchange. They had
no idea what I was talking about and unfortunately few people are familiar with
the law and that means the loss of opportunity to make money
To me, Real Estate is a great way to invest your money and
the opportunity to grow tax free makes it even more inviting. Lets look at the
1031 exchange law:
1st
Requirement: Like-Kind Property
The first requirement for a 1031
exchange (rollover) is that the old property to be sold and the new property to
be bought are like kind. This is frequently one of the most misunderstood
concepts involving 1031 exchanges. Like-kind relates to the use of properties.
As a result, the old property as well as the new property, must be held for
investment or utilized in a trade or business. Vacant land will always qualify
for 1031 treatment whether it is leased or not. Furthermore commercial property
may be used to purchase a rental home or a lot may be sold to buy a condo.
Section 1031 expressly states that
property strictly held for resale does not qualify for an exchange. This means
that investors and developers who strictly “flip” properties do not qualify for
exchange treatment because their intent is resale rather than holding for an
investment. There are numerous court cases seeking to determine the dividing
line between held for resale and investment. Intent appears to be the single
most significant factor in determining the difference.
2nd Requirement: 45 Day Identification Period
The Internal Revenue Code requires that the new property be identified
within 45 days of the closing of the sale of the old property.
The 45 days commence the day after closing and are calendar days. If the
45th day falls on a holiday, that day remains the deadline for the
identification of the new properties. No extensions are allowed under any
circumstances. If you have not entered into a contract by midnight of the 45th
a list of properties must be furnished and must be specific. It must show the
property address, the legal description or other means of specific
identification.
Up to three potential new properties can be identified without regard to
cost. If you wish to identify more than three potential replacements, the IRS
limits the total value of all of the properties that you are identifying to be
less than double the value of the property that you sold. This is known as the
200% rule. Accordingly, more than three properties may be identified as
replacements however, if the taxpayer exceeds the 200% limit the whole exchange
may be disallowed. As a result, the logical rule for investors is to keep the
list to three or fewer properties. It is the responsibility of the qualified
intermediary to accept the list on behalf of the IRS and document the date it
was received however, no formal filing is required to be made with the IRS.
3rd Requirement:: The 180 Day Purchase Period
This rule is simple and straight forward. Section 1031 requires that the
purchase and closing of one or more of the new properties occur by the 180th
day of the closing of the old property. The property being purchased must be
one or more of the properties listed on the 45 day identification list. A new
property may not be introduced after 45 days. These time frames run
concurrently, therefore when the 45 days are up the taxpayer only has 135 days
remaining to close. Again there are no extensions due to title defects or
otherwise. Closed means title is required to pass before the 180th day.
4th Requirement: Use of a Qualified Intermediary
Sellers cannot touch the money in between the sale of their old property and
the purchase of their new property. By law the taxpayer must use an independent
third party commonly known as an exchange partner and/or intermediary to handle
the change. The party who serves in this role cannot be someone with whom the
taxpayer has had a family relationship or alternatively a business relationship
during the preceding two years. The function of the exchange
partner/intermediary is to prepare the documents required by the IRS at the
time of the sale of the old property and at the time of the purchase of the new
property. The intermediary must hold the proceeds of the sale in a separate
account until the purchase of the new property is completed. The taxpayer is
entitled to the interest of these funds and must treat the interest as ordinary
income during the period of escrow.
5th Requirement: Title must be mirror image
Section 1031 requires that the taxpayer listed on the old property be the
same taxpayer listed on the new property. If you and your wife are married and
sell the old property than you and your wife must also be on the title to the
new property. If a trust or corporation is in title to the old property that
same trust or corporation must be on title to the new property.
If only the husband is on the old property, but his wife is required to be
on title to the new property to help qualify for the loan, one solution to
avoid this problem prior to the sale would be for the husband to Quit Claim his
interest to himself and his wife. Similarly, if shareholders of a corporation
or partners in a partnership or members of a LLC are desirous of selling their
respective corporate interest, this is prohibited. What qualifies for 1031
treatment is real estate and not partnership interests. To accomplish this
objective the entity must be liquidated and deeds must be issued to provide the
respective partners with a tenants in common interest in lieu of a partnership
or related interest.
6th Requirement: Reinvest Equal or Greater Amount
In order to defer 100% of the tax on the gain of the sale of old property,
the new property must be of equal or greater value. There are actually two
requirements within this rule. First, the new property has to be of greater or
equal value of the one which is sold. Secondly, all of the cash profits must be
reinvested. In reality you may deduct closing expenses and commissions from the
sale of the property being sold. If the property is being sold for $500,000.00
and the actual net amount after closing expenses is $465,000.00 all that is
required to be spent for the replacement property is a total of $465,000.00.
Closing expenses associated with the purchase may be added into the purchase,
as well as capital improvements completed within 180 days together with
furnishings. In fact, a taxpayer may make an unlimited number of capital
improvements as well as spend up to 15% of the acquisition cost on personal
property.
7th Requirement: Reverse Exchanges –
Title To Both Properties Cannot Be In
Same Name at Same Time
All previous requirements are applicable…..and then some. A reverse may come
in handy when a seller does not yet have a buyer for the property that he
wishes to sell and is afraid of losing the new property he wishes to acquire.
In the fall of 2000, the IRS issued a revenue procedure that established the
concept of an exchange accommodation title holder (which is actually another
name for a qualified intermediary). Simply put, a taxpayer may not have both
the old as well as the new property titled in their name at the same time and
still qualify for a reverse exchange.
The IRS has set up guidelines which allow the taxpayer to acquire the new
property before the old property is sold provided title is taken in the name of
the exchange accommodation title holder (typically a limited liability company
which is created). Under this scenario an entity, other than the taxpayer, will
hold legal title in what is commonly referred to as a qualified parking
arrangement until such time as the old property is sold. The old property must
be sold and closed within 180 days of first acquiring title to the new
property. As soon as the old property is sold the proceeds are then directed to
the exchange accommodation title holder at which time the property may be
deeded out of the parking arrangement directly to the taxpayer. This procedure
is actually quite simple provided cash is utilized to fund the new purchase.
The vast majority of lenders simply will not lend funds to a third party entity
and only to the taxpayer.
If financing the new property cannot be avoided then title must be conveyed
out of the taxpayers name to a straw person prior to acquiring the new
property. This will avoid having title to the old property and title to the new
property being in the taxpayer’s name at the same time which is a prohibited
transaction. Although this is an acceptable procedure to the IRS the conveyance
to the straw person must be reported as an arm’s length transaction the straw
person will then convey title to the ultimate purchase. This is an expensive
proposition in Florida as Documentary Stamps must be paid on the conveyance to
the straw person and then once again on the sale to the ultimate third party
purchaser.
Summary
In conclusion, there are countless scenarios involving 1031 exchanges with
each and every one being unique with its own set of facts and circumstances. If
you understand the seven technical requirements set forth above, you clearly
understand 95% of all aspects of Section 1031 of the Internal Revenue Code. If
you have questions, or have facts or circumstances which you are uncertain of,
I would greatly encourage you to consult a CPA or an attorney who has
experience and is knowledgeable with 1031 tax deferred exchanges.
Information from
Ronald S. Webster Attorney
A.D. Cantelmo Property
Management Specializes in Property Management in Orange County
Ca.