|
The IRS taxes all income. When someone sells real estate they own for a profit, it becomes taxable income unless there is an exemption or deduction that excuses the Seller from paying that tax.
If a homeowner sells their property for a profit, the IRS allows for deferred taxation on the sale of the principle residence under several circumstances. In the simplest of terms, an individual earning more than $250,000 or a married couple earning more than $500,000 may have to pay some taxes on their gain. Current tax law allows almost all principle residence homeowners to defer any taxation as long as they buy another principle residence with the income from the sale of the prior principle residence.
A 1031 Exchange is a section of the tax law that allows property owners to sell property and defer the taxable gain if the property was held for productive use in a trade or business, or for investment. Section 1031 is designed solely for investors and persons engaged in a trade or business and it allows an investor to defer their taxable gain on the sales of real estate. Sellers who are selling their principle residence typically do not need this type of tax treatment because the tax code already allows them in most cases to defer their gain when they sell their property.
A 1031 exchange, also known as a like kind exchange, is the tax deferred exchange of one property for another. Like kind is construed very broadly and most real estate is considered like kind. The simplest form of like kind exchange is where a Buyer and Seller have properties of equal value in which they directly convey the properties to each other with no money exchanging hands. This, however, is rarely practical.
More commonly, some form of IRS-recognized “Safe Harbor” is used. The Seller, or exchanger, sells their property to a Buyer but the Seller does not receive any money. Instead, that money is held by a third party, commonly known as a qualified third party intermediary. The intermediary holds the funds until the exchanger selects a new property to purchase. Under IRS rules, the exchanger has 45 days to designate 1 or more properties and then has 180 days to go to settlement. At settlement, the intermediary pays the exchanger’s held funds to the Seller of the new property. In this way, the exchanger never actually receives the funds but has exchanged one property for another.
If the new property does not use all of the funds from the original sale, there can be taxable gain on those funds not used. If the new property costs more than the original sale, the exchanger will have to bring additional funds to settlement in the form of a loan or their own money.
Because there are many scenarios in the tax deferred exchange process, you should consult with your tax preparer and attorney regarding the details or methods of any exchange you are considering.
|
