Since 1921, Internal Revenue Code 1031 has encouraged investment property owners to trade their properties to avoid paying capital gains tax. Fortunes have been made by taking advantage of this tax-deferred exchange of investment and business properties. Yet even savvy real estate investors may fail to consider IRS Code 1031.
How does it work? To qualify for a tax-deferred exchange, a real estate investor must trade “equal or up” in both price and cash or net mortgage relief on like-kind property.
It’s important to know that “like kind” property does not mean “same kind.” For example, investors may trade a rental house for a warehouse or an apartment building for an office building. Vacant investment land could be traded for a shopping center. Almost any real estate held for investment or for use in a trade or business is eligible. Not eligible, according to the IRS Web site, are inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.
To comply with Code 1031 and the subsequent Internal Revenue Code 1031(a)(3), commonly called Starker exchanges, proceeds must be held in trust by an independent third party or Qualified Intermediary. If the seller or any agent of the seller takes possession of the funds during the exchange, the sale becomes taxable.
To qualify for deferral, exacting adherence to the code is necessary. Therefore, it is critical to select a Qualified Intermediary who possesses a thorough understanding of all the details of the regulations, preferably someone who specializes in this type of transaction.
A Qualified Intermediary is an entity established by the code to act for taxpayers without being deemed their agent. Documentation for the exchange must be in place before the transfer of any property. Proper documentation and tracking are vital; otherwise, taxes will be assessed against the seller.
Answering that need in Southern Nevada is Henderson-based Southwest Exchange, established in 1990 as an independent Qualified Intermediary for IRS Code 1031 tax-deferred exchanges.
Southwest Exchange founder Betty Kincaid explained exchanges provide a tax haven for preserving real estate wealth. She compared the concept to an IRA account or a 401(k) plan. “You keep building on your investment,” Kincaid said. “You’re using what you would have paid in taxes to invest in a higher-valued property, which in turn gives you a better return and a better long-term appreciation. Technically, you could exchange forever and not pay taxes. ”
After the sale of the old investment property, the trader has 45 days to designate the qualifying replacement property. The trader then has 180 days from the sale date to complete the acquisition.
According to the experts, a few basic reasons for tax-deferred exchanges include: to pyramid equity without paying capital gains tax; to trade a hard-to-sell property with one more easily marketed; to eliminate or minimize the need for new financing on the acquired property; to acquire a property that is easier to manage; to acquire a property with greater profit potential; or to receive tax-free refinance cash either before or after the exchange.
“Like almost everything associated with the IRS, a significant amount of paperwork is involved. People really have to know what they’re doing. It’s also very important that the counseling clients receive is delivered accurately and consistently,” Kincaid said.
“We give free educational classes to real estate agents and investors, and believe that educated clients make informed decisions,” she added.
Southwest Exchange’s management has, over the last few years, made a commitment to more growth, profitability and expansion in Southern Nevada. “We’re also getting a lot more regional recognition in California, Arizona and Utah,” said Kincaid.
The company is one of the largest independent qualified intermediaries in the U.S., handling in excess of half a billion dollars annually in transactions.