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May 5, 2010 - Dylan Renz
I have recently had a number of customers ask about the possibility of a 1031 Exchange so I figured that would be a good topic to cover. A 1031 exchange is simply an exchange of property that allows you to defer any captial gains tax.
Before we go any further, here is the disclaimer. I am not an accountant or an attorney and I suggest that you seek the advice of both before going forward with a 1031 exchange, but here are some things to think about...
Why a 1031 exchange?
The reason is simple. The IRS allows you to defer any captial gains tax associated with the property when it is exchanged rather that simply sold. This means that you can adjust your investments without paying the taxes. Let's say you own three vacant lots in Ohio and would rather own an investment property that is income producing such as a condominium in Florida. The IRS will allow you to exchange your vacant lots for a condominium and defer the captial gains tax.
What types of 1031 exchanges exist?
There are a number of different types of exchanges, but the two most common are the simultaneous exchange and the delayed exchange. A simultaneous exchange occurs when both properties are exchanged (or traded) at the same time. A delayed exchange (the most common type) occurs when a property is sold, the funds are held onto by a qualified intermediary, and a new property is purchased using those funds within a limited amount of time, currently 180 days.
What kind of properties qualify?
Any real property being held for trade or business or as an investment qualifies and both the property you are giving and receiving must qualify for a valid exchange. This means that you can not exchange a commercial property for a primary residence, but you can exchange a commercial property for a home you plan on renting out.
What are some of the problems with 1031 exchanges?
The primary problem is that most of the customers who have approached me about 1031 exchanges are interested in simultaneous exchanges. They want to trade their property for another and avoid the frustration and expense of selling as well as the taxes. The primary problem with this tactic is that it is a very specific deal and finding a property owner with the property you want, who is interested in the property you have, can be like finding a needle in a haystack.
For example, let's say that you own a great condominium in Logansport, Ohio and you want to complete a simultaneous exchange for a waterfront lot on Pine Island. You will need to find an owner who has a waterfront lot on Pine Island and is willing to exchange it for a condominium in Logansport. That is a pretty specific person who may be incredibly difficult to find, if they exist at all.
The other common problem with 1031 exchanges is that they can often be cost prohibitive, especially on smaller properties. Even though you are saving on the captial gains tax, you will still have closing costs, commissions, attorneys fees, accountant fees and/or fees associated with hiring a qualified intermediary. Unless the tax savings is substantial, it may be cheaper to simply sell one property and buy another.
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