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(As published by Eric Risberg in the Business Location Guide of the San
Francisco Business Times)
This tax shelter is probably one of the best kept secrets in the Internal
Revenue Code. It has been overlooked by both the general public and many
professionals who are uninformed or misinformed about the potential
opportunity to avoid the capital gains tax normally incurred upon the sale
of real estate property.
In essence, it provides that if a piece of business or investment property
is sold and another property is purchased to replace it within 6 months,
then the sale/purchase can be structured to be tax-free. In San Francisco,
many properties have more than doubled in value over the past three years.
Consequently, any San Francisco property owners wishing to sell their
property and take advantage of this exceedingly strong market will likely
face a large capital gains tax burden when they sell their property.
Deferred exchanges can be a very useful tool to investors seeking a tax
shelter from the capital gains associated with their current property's
market value appreciation.
Tax deferred exchanges have been around since the 1920's. In the past,
individuals were limited to simultaneous exchanges. That meant you had to
find another person like yourself and exchange properties in the same
closing. Sometimes three or more people would get involved; all swapping
properties with each other at the same time. In some instances, exchanges
would fall apart at the last minute and people would get stuck owning
properties that they didn't want. During the 1990's the IRS set down new
guidelines which formed a new tax shelter vehicle known as deferred, or
"Starker Exchanges".
In completing a delayed exchange you now have 45 days to select the
replacement property which you intend to purchase, after the transfer of the
relinquished property, and must acquire the new property within 180 days of
the first closing. It is also critical that you do not receive the sale
proceeds from the relinquished property. Pursuant to Section 1031 and the
regulations, this cash may not be actually or constructively received by
you. One of the IRS requirements for a delayed exchange is to have an "IRS
Qualified Intermediary" execute the transaction for the taxpayer. It is
very important to use a trustworthy and qualified company for this purpose.
Most often the Qualified Intermediary is a representative from a title
company that has been specifically trained in handling tax deferred
exchanges, but may include law firms or other businesses which specialize in
providing assistance in 1031 transactions.
Beyond the ability to defer or eliminate capital gains tax, 1031 exchanges
can also be a key part of an investment strategy for the following reasons:
1.) Since you can defer the payment of the tax, you have more cash to invest
in a replacement property. This means you make a return on the money you
would have otherwise paid in taxes and thus can increase the cash flow from
your investment. You could use it, for example to transfer your investment
from non-productive bare land to cash flow rich commercial property.
2.) An exchange can be used to consolidate multiple properties into one
property to ease your management burdens. Conversely, you can convert a
large property into several small properties to help you manage the
recognition of gain over an extended time frame or to diversify your risk.
3.) You can also change the location of your real estate investment. It is
possible to relocate your investment across town or across the country where
you may achieve a higher return on your money. Ownership of property can
be changed from an over-inflated and volatile real estate market in one
city, to a more stable or higher growth market in another region of the U.S.
4.) You can defer the taxable gain of all qualifying property to an
anticipated lower tax rate in the future, as is usually the case when you
retire.
Tax deferred exchanging is an investment strategy that should be considered
by anyone who owns investment or business-related property. But please be
aware that as with any broad-brush discussion that addresses the US Income
Tax Code, the issues are much more complex and detailed than presented here.
I strongly recommend that anyone considering a tax-deferred exchange seek
the advice of a competent tax professional.
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