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1031 Exchange

One method that can be used to defer tax in Boston, Massachusetts, is to take advantage of a 1031 exchange as set forth by the Internal Revenue Service (IRS). Under Section 1031 of Internal Revenue Code (IRC), home buyers, real estate investors and people purchasing land or commercial real estate can defer tax liability with a like-kind exchange. While this method has not always been popular, the term 1031 exchange has recently worked its way into regular conversation between property investors, brokers and agents. However, many people who are in a position to take the tax deferment still do not understand exactly what like-kind exchanges are and how they can be implemented.

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What Is IRC Section 1031?

Under IRC Section 1031, many property owners can defer tax on capital gains when they sell their commercial land or real estate and use the proceeds to reinvest in like-kind property. However, several important rules are in place that must be followed in order to become eligible for the deferment. This IRS rule is still largely unknown to those buying second homes in Boston, Massachusetts, because it is meant for business investment.

Who Stands to Benefit?

Most people who will realize a net gain from the sale of non-personal property may be able to take advantage of a like-kind exchange. The following types of property could be eligible: commercial real estate, investment property and vacation homes. In addition, property that was previously used for a business but has since been retired may also qualify. However, 1031 exchanges are not normally allowed for property that is meant to be flipped. The investor must be seeking long-term gains through appreciation.

To qualify under Section 1031, you cannot be a property dealer, which is defined as someone who purchases property to hold as inventory or for the express purpose of reselling.

Vacation Homes and Second Homes

It is important to note that a substantial amount of confusion exists about claiming Section 1031 for vacation homes and second homes. Strict regulations exist concerning like-kind exchanges and second homes that must be followed, and the chief of these is that the property cannot be meant for personal use. Until 2008, these regulations did not exist, and nearly any type of property could be claimed as an investment vehicle.

Because so many people who exchanged homes for personal use were taking advantage of Section 1031, the IRS created Revenue Procedure 2008-16, which defines the types of property that are acceptable. The rules for this must be met for two years prior to the exchange and for two years afterward and are as follows:

Overview of 1031 Exchanges

When properties are productively used in a business, a trade or for long-term investing, they may be exchanged for other properties that are meant to be used in the same manner. These types of properties are usually considered to be like kind even if they have major differences in type, character or quality, but they must both be located in the United States or a U.S. territory.

Examples of property that may be considered for like-kind exchanges include the following:

In addition, equipment used on a qualifying property that is included in the price at the time of sale may also be deferred of capital gains tax as long as its value does not exceed 15 percent of the value of the larger property.

At one time, Section 1031 deferments could only be claimed when ownership of the two properties was transferred simultaneously, but now, a contract that commits to a future exchange is considered to be equal to simultaneous transfer when it meets specific time requirements and when the sale is facilitated by a qualified intermediary.

Identification Period and Time Limits

Properties for which 1031 exchanges are claimed must meet strict time limits. The exchange is said to begin on the earlier of the following two dates: the date the deed is recorded or the date possession is transferred. The exchange will then end on the earlier of these two dates: 180 days after the exchange begins or the date the exchanger's federal tax return is to be submitted after all extensions have been exhausted.

In addition, if the exchanger has multiple properties included in the exchange, then it begins when the first property is transferred. Weekends and holidays are included in the time limits for 1031 exchanges. When the due date falls on either, the exchange must be completed on the business day immediately prior. The only way that these deadlines may be lifted is in the case of a related disaster as declared by the president of the United States.

The first 45 days of the exchange is known as the identification period. Within the identification period, the seller must be able to name one or more replacement properties for the property that was sold. The replacement properties must abide by one of the following three rules:

Other Stipulations of Section 1031

Section 1031 includes several additional stipulations, including the following:

Eight Steps to a Successful 1031 Exchange

  1. Receive advice from or retain the services of a certified public accountant (CPA).
  2. Sell your original property. A cooperation clause explaining that the buyer is aware of the seller's intention to file an exchange based on Section 1031 should be included.
  3. Contact a qualified intermediary, and enter into an exchange agreement. An amendment to any escrow must name the qualified intermediary as the seller. The deed will still reflect the name of the actual seller.
  4. When the sale closes, proceeds go directly to the qualified intermediary, usually in the form of a segregated money market account.
  5. Identify the replacement property to the qualified intermediary. The identification must be made in writing within the time limit for the exchange, and it must be signed by each party named in the exchange agreement.
  6. Enter into a contract to purchase the replacement property. As when selling, the agreement should include a cooperation clause. An amendment to the contract names the qualified intermediary as the buyer, but the name on the deed will be that of the true buyer.
  7. When the sale closes in the name of the qualified intermediary, the funds are forwarded to escrow. The qualified intermediary is then responsible for delivering a final accounting to the taxpayer.
  8. When filing a federal tax return, you must complete IRS Form 8824 and any other documents required for your state taxes.

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