The best way to defer capital gain taxes which would normally arise from the sale of investment property is the IRS 1031 Tax Deferred Exchange. Exchanging defers the realization of capital gain tax, allowing the property owner to reinvest his/her proceeds into a replacement property. According to the tax code, "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment purposes if such property is exchanged solely for property of a like-kind which is to be held for either productive use in trade or business or for investment purposes." Investors can reach their investment objectives with exchanges by enjoying greater leverage, diversification, freedom from joint ownership, improved cash flow and property consolidation.

An exchange is also referred to as a "non-taxable sale." It is a method of enabling property owners to trade an investment property for another investment property (or properties) without paying capital gain taxes on the transaction. In a taxable transaction the owner is taxed on any gain realized by the sale of the property. In an exchange, the tax is deferred; the earning power of deferred taxes is for the benefit of the property owner.

To qualify for tax deferral, the Exchanger must exchange the relinquished property for a "like-kind" replacement property following the terms of the Exchange Agreement. An agreement to sell and subsequently purchase does not qualify. The Exchanger must enter into an agreement with either the seller of the replacement property or the buyer of the relinquished property or a Qualified Exchange Intermediary.

The basic rule for deferral of the entire capital gain tax is that the Exchanger use all cash proceeds in the exchange account to acquire replacement property, have equal or greater debt on the replacement property, and receive only like-kind property.

The 1031 Exchange is TAX DEFERRED...not TAX FREE!

A property owner has three alternatives in order to legally avoid paying capital gain tax:

1. Continue to exchange

2. Refinance - refinance a property owned after it has been held for investment or income purposes and obtain a portion of the accumulated equity.

3. With an Exchanger dies, all of the capital gain tax is forgiven and the heirs receive the property with a "step-up" in basis to the fair market value at the time it is inherited. EXCHANGE TERMS:

1. Assignment Agreement - a document used to transfer contractual rights to a third party; used to assign the purchase/sales agreement between the Exchanger, Qualified Intermediary and either Buyer or Seller

2. Basis - method of measuring investment in a property for tax purposes. Formula = Purchase Price plus Improvements less Depreciation Deducted equals Adjusted Basis

3. Boot - fair market value of the non-qualified (unlike-kind) property received in an exchange. (Cash, notes, furniture, supplies, debt reduction obligations, etc.)

4. Capital Gain/Loss - increase/decrease in amount received from the sale or exchange over the adjusted basis of property

5. Constructive Receipt - proceeds of a taxpayer that may not directly be in his/her possession

6. Exchange Agreement - document used to establish contractual relationship between the parties to an exchange which restricts the Exchanger’s access to funds and outlines the duties of the Intermediary

7. Exchanger - party completing the exchange (taxpayer)

8. Like-kind Property - any property used for the productive use in a trade or business or for investment is deemed to be like-kind with any other property to be used for the productive use in a trade or business or for investment.The way the property is used, not the type of property, determines if it is like-kind; refers to the nature of the property and not its quality. Can include single-family residential, mullet-family residential, retail, condos, offices, industrial warehouses, commercial buildings, raw land. Exceptions include an interest in a partnership, primary residences, vacation homes/second homes and inventory

9. Qualified Intermediary - an entity who is not an agent of the taxpayer or a disqualified person and enters into a written agreement with the Exchanger. The Qualified Intermediary acquires therelinquished property from the taxpayer, transfer the property, acquires the replacement property and transfers the replacement property to the taxpayer.

10. Relinquished Property - property sold by the Exchanger; also called the "exchange downleg" or "phase 1" property

11. Replacement Property - property acquired by the Exchanger; also call the "acquisition," "upleg," or "phase II" property

12. Starker Type Exchange - term for the delayed exchange variation, upheld in the case of Starker vs. United States

EXCHANGE VARIATIONS

a. Simultaneous Exchange - the sale of the relinquished property and the purchase of the replacement property occur on the same day. The closings are contingent upon each other, and the Qualified Intermediary format offers the protection under the IRS regulations by not leaving funds with the escrow officer.

b. Delayed Exchange - the Exchanger has a maximum of 180 days from the date of closing on the relinquished property to acquire the replacement property. The Identification Period of identifying the replacement property or properties is 45 days from closing; Exchanger has total of 180 days from date of closing to close on the acquired property. Identification is limited to three properties of any value, or limited to any number of properties with an aggregate fair market value not to exceed 200% of the property value sold, or 95% of the value of all properties identified are actually acquired.

c. Reverse Exchange - the investor locates a replacement property and acquires it before selling the relinquished property to a buyer. The Intermediary is the owner and is on title to either property for a period of time.

We strongly recommend consulting a Qualified Exchange Intermediary and/or Tax Advisor after your real estate broker assists you in selling and locating potential replacement properties.

Kathie Salera
702.682.4131
Kathieb@americanagrp.com