If you are looking for a true tax shelter for your investment returns...deferred exchanges are a great way to avoid paying taxes on real estate profits. Not only can you defer paying taxes, you can put this tax money towards a new real estate investment.
Basically, a deferred exchange consists of your trading properties instead of selling them outright. If you exchange a property for a property of equal or greater value, you do not have to pay capital gains taxes on the profit. For example, if you bought a piece of land for $50,000 and sold it $100,000 your capital gains would be approximately $50,000 (minus improvements, selling costs, etc.)
If you sold the land for cash you would have to pay state and federal taxes on the $50,000 capital gain, approximately $10,000 out of your gain. However, if you exchange the property for another property worth $100,000 or more...you will not have to pay capital gains tax; you have successfully sheltered your gains.
This exchanging of properties is called deferred exchange and has certain rules and regulations that must be followed. The regulations are defined in the Internal Revenue Code section 1031, and must be followed exactly or the exchange may be deemed invalid, in which case you would have to pay the capital gains tax.
There are two phases to a qualified exchange: Phase I consists of the Exchanger turning the property over to a qualified intermediary (see glossary.) Then the Exchanger has 45 days to identify a replacement property. The replacement property must be of equal or greater value, and must be like kind (any investment real estate is like kind.) Phase II consists of the qualified intermediary selling the original property, and purchasing the replacement property for the Exchanger. The entire process may take no longer than 180 days.
The advantage of this process is that it allows you to accumulate personal wealth without paying capital gains taxes. Eventually, you may want to sell your properties for a profit, at that time you will have to pay capital gains tax, but it will be at your choosing. You may also wait until your retirement years and pay the taxes when you are in a lower tax bracket. For an example of how a deferred exchange can save you money, see our sample exchange page.
The most crucial aspect of the deferred exchange is your choosing a qualified intermediary, also called an accommodator. The accommodator must not have any financial interest in the sale or purchase of the property. This means that your realtor or CPA may not be the accommodator for a legal deferred exchange. If an attorney is needed for the exchange, they must be appointed by the accommodator.
The accommodator must sell the original property and hold the funds in a trust account until the replacement property has been identified. The accommodator then takes the funds and applies them to the purchase of the replacement property. While the funds are in escrow the exchanger can not access or have use of the funds. This is an IRC regulation; removing the funds from escrow will cause the gains to be taxable. For more information, please visit our FAQs page. Click here to read the IRC section 1031 online.
Title Exchange Company is an IRC 1031 Qualified Intermediary. We have attorneys on staff to handle your exchange with the utmost of care and professionalism. If you have further questions you can give us a call or jump to our Contact Us page to e-mail us.