It is a requirement of a 1031 Tax Deferred Exchange that the purchase of the replacement property must occur within 180 days of the sale of the relinquished property in order to defer capital gains tax on the profits. However, if the 180-day period extends into the next tax year, it raises the question of in which tax year the capital gains tax will be due.
Specifically, if the 180 days "straddles" two years, the question arises as to whether the capital gains tax is due in the year the relinquished property was sold or the following year.This flexibility allows the seller to align the payment of capital gains tax with their personal financial situation and goals.
Basics of a 1031 Tax Deferred Exchange
The 1031 Tax Deferred Exchange provision in the IRS Tax Code incentivizes real estate investment by allowing investors to defer capital gains taxes while acquiring more valuable properties and rental income. Through a series of purchases and sales, an investor can swap one property for multiple or vice versa. However, it is important to note that the tax entity that sells the property must be the same as the one that buys it.
The Internal Revenue Service (IRS) specifies precise requirements that an exchange must follow in order to be eligible for a 1031 exchange. Any violation of these guidelines could result in capital gains being paid by the investor.
Investors must adhere to a tight timetable after selling the initial property, sometimes referred to as the "relinquished property," in order to complete a 1031 exchange. After 45 days, an investor has 180 days to find a "replacement property" and close on it. Both dates are determined starting on day zero, which is the day the property was given up for sale.
As long as their decision complies with one of three criteria outlined by the IRS, investors are free to choose as many properties as they want. The properties can be of different types, for example, a primary residence can be sold and replaced with a commercial property or a multi-family building can be exchanged for a single family home to be used as a vacation rental.
● In a 1031 exchange, the property sold (referred to as the "relinquished property") and the property bought (referred to as the "replacement property") must be of "like-kind."
● A Qualified Intermediary (QI) is used to handle the proceeds from the sale and purchase of the properties. The QI is a third party that is specifically established for this purpose, and no money from the sale goes to or is handled by the seller.
● Within 45 days of selling the "relinquished property," the seller must submit a list of up to three potential "replacement properties" or properties valued at up to 200% of the sale price of the relinquished property to the QI.
● From this list, the seller must choose the “replacement property” or properties to purchase.
● The seller has 180 days from the closing of the "relinquished property" to close on the "replacement property."
● The purchase price of the "replacement property" must be equal to or higher than the sale price of the "relinquished property in order to fully defer all taxes
● If all profits from the sale of the "relinquished property" are used for the purchase of the "replacement property," and all debt replaced, if any, no capital gains tax is due (deferred).
● If the seller does not utilize all of the profits from the sale of the "relinquished property" for the purchase of the "replacement property," capital gains tax is only due on the portion not used.
“The Tax Straddle Strategy”
In the case of a 1031 exchange where the sale of the "relinquished property" closes after early July, the 180-day period in which the closing of the "replacement property" must occur may fall into the next calendar year. If the closing does not occur within this 180-day period, the exchange is considered to have failed.
The proceeds from the sale of the "relinquished property" are returned to the seller from the Qualified Intermediary and capital gains tax is due on any profits from the sale of the "relinquished property". However, the IRS allows the seller to choose in which tax year they will be subject to tax, either the year of the sale or the year of the failed purchase, as the 180-day period "straddles" two tax years.
The ability to choose when to pay capital gains taxes can be a significant advantage for the seller in a 1031 exchange. In the event of a failed exchange, where the closing of the "replacement property" does not occur within the 180-day period, the seller has the flexibility to make a strategic decision that aligns with their financial goals.
They can either pay capital gains taxes for the year of the sale of the "relinquished property" or choose to defer the taxes and use the proceeds for any purpose for an entire calendar year, before paying the taxes in the year of the failed exchange. This flexibility allows the seller to potentially invest or save the proceeds for a year, or even to use them for other real estate investments, before paying taxes on the profits of the sale of the "relinquished property”.
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
- There is no guarantee that any strategy will be successful or achieve investment objectives;
- Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
- Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- Potential for foreclosure – All financed real estate investments have potential for foreclosure;
- Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits