With the purpose of stimulating the economy, the Internal Revenue Service (“IRS”) aimed to encourage the commerce of Real Estate (“R.E.”) through Section 1031 of the Internal Revenue Code (“IRC”). This Section allows R.E. investors to defer the capital gain tax when selling a property and reinvesting the proceeds in like-kind property held for productive use in a trade or business, or held for investment. Capital gain is generally calculated on the difference between the purchase price of the R.E. plus purchase expenses improvement and remodeling costs minus amortizations and net selling proceeds.
Advantages of Section 1031 are, amongst others, that the seller can dispose of the property deferring income tax liability, allowing the investor to increase the purchasing power of money and to maximize the return on the investment.
Please note that Section 1031 does not apply to exchange of stocks, bonds, notes, securities, or interests in the assets of a partnership or LLC.
According to Section 1031, an investor will have to comply with the following requirements:
- The relinquished property (i.e., property the investor is selling) and the replacement property must be located in the U.S.;
- Within 45 days of closing, the investor must provide a qualified intermediary (or exchange facilitator) with a list, identifying potential replacement properties;
- Within 180 days of the sale of the exchanged property, the investor must complete the exchange with at least one of the listed properties;
- The investor must take title to the replacement property in the same legal name of the relinquished property;
- The value of the replacement property must be similar or higher to the value of the relinquished property;
- The investor must reinvest all the cash proceeds from the sale in the replacement property, any cash received is subject to taxation. As a very simplified example, if the investor purchased a property for $2,000,000.00 and later reinvests in a $1,500,000.00 property, the $500,000.00 balance would be subject to federal capital gain tax at a maximum rate of 20%. The chart below shows the applicable rates depending on the amount of gain
|$72,500 or less|
|$72,501 – $450,000|
|$450,001 and over|
It is worth noting that some states impose state capital gain tax, which would add to the maximum federal rate of 20%.
Furthermore, the identified replacement property must follow one of three rules:
- The Three-Property Rule: The investor may identify up to three different properties as possible replacements, without consideration of the market value. This rule applies to 95% of the transactions;
- 200% Rule: The investor may identify different replacement properties, so long as the total value of all the potential replacement properties does not exceed 200% of the market value of the relinquished property;
- 95% Exemption: The investor may identify any number of replacement properties, so long as the replacement property’s value represents at least 95% of the aggregate value of all the identified properties.
Through the exchange process, the investor will always carry over the relinquished property’s basis to the replacement property (i.e., the value of the relinquished property, plus improvements, minus amortization). However, heirs of the taxpayer will receive the property at its market value as long as all applicable estate taxes have been paid. Later, when the property is sold, only the amount resulting from the difference between the new purchase price and the fair market value at the time of the taxpayer’s death will be subject to taxation.
In sum, R.E. in the U.S. has different tax benefits that not only stimulate the economy, but also allow investors to maintain stability in the purchasing power of money.
Cav. Piero Salussolia,Esq.;
Lizet Cardozo, Abg. (admitted in Colombia only);
Monica Tirado, Abg. (admitted in Colombia only).
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IUS GENTIUM By: Piero Salussolia P.A.