Within the current down market, many Americans have become unintentional real estate investors, as they are forced to rent out the houses they are unable to sell. While it may be an unwanted situation now, these accidental investors could benefit down the road through tax-deferred exchanges, if they eventually sell the rented house and reinvest in a new property.
When investment property is sold, the profit or capital gain is taxed. In a tax-deferred exchange (sometimes called a tax-free or 1031 exchange), if both the basis and gain are reinvested in a new property, the gain is realized by the taxpayer, but is not recognized by the IRS. The result the gain isnt taxable! If all the basis and gain are not reinvested, only that portion not reinvested in taxed. Investors may use tax-deferred exchanges to reinvest in new properties of different kinds or in different locations. Now, more people will have the opportunity to enjoy the same tax break.
As you might expect, there are strict guidelines that must be followed to properly complete a tax-deferred exchange and avoid paying tax on the capital gain. To qualify, neither the old nor new properties may be primary residences, but must be held for productive or investment purposes. Property can be residential, such as a house that is rented, but cant be the home of the owner. (In a case where the owner lives in portion of the dwelling and rents a portion, the percentage of the home value attributed to investment can be exchanged.)
Exchanged properties dont have to be of the same type. For example, raw land can be exchanged for other raw land, an office building, a multi-family rental or even a hotel. However, it cant be exchanged for land outside the U.S., a personal residence, property held primarily for resale, or cash, stocks, bonds or notes.
Tax-free exchanges can be simultaneous, where sold and purchased properties close at the same time; delayed, where the old property is sold and the new property is purchased at a later date; or reverse, where the new property is purchased and the old property is sold at a later date.
Tax-free exchanges also require the work of a qualified intermediary who assists the taxpayer. The intermediary holds the exchange proceeds or title, acts as the principal in the sale and purchase of property and may drafts legal documents. The intermediary cant be the taxpayer or a related party, which includes family members and business associates, such as real estate agents or attorneys who represented the taxpayer within the past two years. The safest way to obtain a qualified intermediary is to seek the services of a title company.
After the original property is sold, the exchanger has 45 days to identify replacement property he intends to exchange and 180 days to complete the acquisition. Single or multiple replacement properties can be purchased as long as they follow specific identification rules.
As you can see, accidental investors have the potential to greatly benefit from tax-free exchanges. If interested in seeking out this opportunity, it is essential to consult a tax attorney and/or a certified public accountant for specific advice.
Howell Haunson is director of education for Morris|Hardwick|Schneider, one of the largest real estate closing law firms in the United States, and LandCastle Title, M|H|S title company. He also serves as vice president of LandCastle. Haunson has been practicing real estate law for more than 25 years. He is an adjunct professor of law at John Marshall Law School in Atlanta, has served as a member of the board of directors of the Georgia Real Estate Closing Attorneys Association and is actively involved in presenting lectures and seminars relating to real estate issues throughout the country.