Tax Deferred 1031 Exchange
This information applies directly to anyone planning to exchange property or who may need to exchange property some day in the future. This information is also of use to anyone planning to buy investment property in the future. I hope this information about 1031 exchange will clear up some common misconceptions about how the IRS defines "like kind" and provide you with enough knowledge about 1031 exchanges to steer you in the right direction.
There is no need to do an exchange on a Principal Residence because there is a built in $250K deduction for each spouse. 1031 Exchange is only for investment property.
Most people have heard that the IRS requires you to exchange "like for like". However, many people mistakenly believe this means raw land for raw land, apartment house for apartment house, etc. NOT SO! It means gold for gold, silver for silver, trucks for trucks and DIRT FOR DIRT. Investment property is defined as raw land, a rental house, business property, duplexes or apartments, a B&B, or basically ANY TYPE OF REAL ESTATE, even a single family residence if it is being rented out (not your principal residence). Raw land sitting fallow can be considered an investment because you plan to sell it some day to make money! Any type of investment real estate property can be exchanged for any other (but gold, silver, trucks, etc, cannot be exchanged for real estate).
This is important to anyone planning to retire in a nice home or condo somewhere on the Big Island! Here is what you can do if you own raw land or a piece of commercial property or rental property, or any kind of "investment" property (something other than your principal residence). At least a year before you plan to retire to the Big Island, get your raw land or investment property into Escrow (sell it). Fly over and identify a replacement property on the Big Island at least 45 days after your property closes escrow (best to give yourself a head start by looking before the exchange property closes escrow). Let's assume you are going to purchase the home or condo you plan to retire in. You find that home or condo, the exchange takes place, you close escrow on the exchange property and the replacement property. Now, to satisfy the IRS requirement for "investment property for investment property" you must rent the home or condo out for at least one year. That's it! Any time after that first year you can move into your new home in Hawaii and you have avoided paying capital gains on the investment property you sold!!
When you finally do move to the Big Island and sell your principal residence on the Mainland (or Oahu), there is no tax on the first $500,000 of capital gains (for married couples) and you never have to buy a replacement property (the Principal Residence Rule). You can pocket that cash because there is no capital gains tax on up to $500K for your principal residence. And, since you already own a home on the Big Island, you don't have to purchase another home. You simply move into the home or condo that you have been renting out for at least a year and that becomes your new principal residence. You have effectively turned a piece of investment property into a principal residence and AVOIDED CAPITAL GAINS FOREVER!! AND you can sell THAT property after living in it for a minimum of two out of 5 years and the $250,000 exemption per person applies because it's now your principal residence!!
Here are a few reasons why someone might want to do a 1031 exchange: 1. To get better cash flow. You might be able to rent raw land for pasture, but a vacation rental condo in Kona will certainly give greater rental income. 2. Greater appreciation. Homes and condos may increase in value faster than raw land in some locations on the Mainland or Oahu (or even Maui or Kauai). The reason Kona properties might increase in value quicker than the other Islands is because those markets have been active longer and the prices are already higher. Kona is a relatively new market that people are just discovering and prices are lower than the other Islands at this time but going up day by day. 3. Liquidity. You can get a 30 year mortgage on a condo or home but not on raw land. 4. Depreciation. You can't depreciate raw land, but you can a vacation rental condo or rental home. Depreciation is a great tax write off.
That is the beauty of the 1031 exchange. You don't actually trade for someone else's property. Without getting into all the details, first you sell your investment property and then you have 45 days to find another investment property to buy, 180 days total to close on the replacement property. An Exchange Facilitator holds the money from the sale of your property to satisfy IRS regulations. You MUST contact the Exchange Facilitator before your property closes escrow because you cannot be the recipient of the proceeds.
Just to reiterate: The IRS regulations say you have 45 days to "Identify" the replacement property from the day the property you sold closes escrow. Miss that deadline by one second, and you have to pay tax on the gain. That is why I suggest that people identify the replacement property WHILE your exchange property is in escrow, then get the replacement property into escrow in the first 45 days. Identifying the replacement property for IRS purposes only means you give the IRS three possibilities you MIGHT buy in the first 45 out of 180 total days. But what if all three sell? It's better to get one into escrow as soon as possible just to be safe. When you are ready I can assist you with all this.
If you have any questions or want more information on 1031 exchanges (or any type of Real Estate information) please call me at 989-3491 (dial 808 if you live outside the State of Hawaii).
The premise of a 1031 exchange is based on "relinquishing" a property and acquiring a replacement property following a set of rules and guidelines provided by the IRS. Done correctly and following all the rules, a taxpayer may save payment of taxes. The underpinnings of an exchange are based on the continuity of ownership interest in real property. That is, if a taxpayer sells or "relinquishes" a property and receives replacement property, following all required steps, the IRS will look at that sequence of transactions as if the taxpayer never really got rid of a property. It is as if he or she continued to own real estate the whole time.
Key concepts: (1) The major motivation is to keep from paying capital gains taxes on the sale of an investment property. The current capital gains tax rate is 15% for long term gain (profit). For improved property (rental houses, commercial property, etc.) accumulated depreciation deductions must be recaptured and taxes will be due at a rate of 25%. (2) To keep from paying those taxes, the sale of the first rental property must be linked through specific documentation to the purchase of replacement property. (3) The IRS provides two very specific time constraints — 180 days total to acquire replacement property, and 45 days to identify the replacement property in writing on a Target Identification Letter. (4) All of the equity or cash from the first property must be "spent" on acquiring the replacement property, and the total value of replacement property must equal or exceed the value of the relinquished property.