§1031 Exchanges Defer Treatment of Capital Gains, but the IRS will not “Save” a Transaction if the Qualified Intermediary files for Bankruptcy or Otherwise Neglects to Complete the Transaction within Strict IRS Time Frames.
For all that is said and written about taxes, it really boils down to the following;
(1.) when you earn a dollar, you pay income tax (federal, state, local, and so on);
(2.) when you spend that dollar, you pay sales tax;
(3.) if you invest that dollar and you receive a dividend or interest, you pay taxes on the dividends and interest;
(4.) if you invest that dollar and it grows, you pay capital gains taxes when you sell the investment; and
(5.) if you die with that dollar, you pay federal estate taxes (more accurately, and, to be fair to the IRS, if you die with a lot of dollars, and haven't done any estate planning, you pay federal estate taxes.)
Concerning point number (4.), the Internal Revenue Code allows for the deferral of the recognition of gain (and with it, the payment of capital gains taxes) on the sale of appreciated real estate through something known as a “1031 Exchange.”
The Internal Revenue Code §1031 tax deferred treatment of capital gains is one of the best means for preserving and building real estate holdings. The property owner is essentially transferring the financial gain that is realized from the sale of a property to another like-kind property without the recognition of federal capital gains tax at the time of the sale IF the rules in §1031 are closely followed, including the rules that replacement property must be identified in 45 days and the transaction closed in 180 days. If you simply sell your property, accept the proceeds, and reinvest the money in another property, the transaction will not qualify for 1031 exchange treatment, even if the transactions close simultaneously.
The property owner must completely avoid receipt of money or other property during the transaction. If you receive the earnest money deposit or the entire cash proceeds from the exchange of your property, you will not qualify for §1031 exchange treatment. This is not easy to avoid. You must overcome the doctrine of constructive receipt. The general rules concerning actual and constructive receipt apply to determine if you are in actual or constructive receipt of money or other property before you actually receive like-kind Replacement Property.
A reputable, financially stable Qualified Intermediary can provide the vehicle necessary to avoid receipt of any of the proceeds and allow you a limited extension of time to identify replacement property (within 45 days) and close the transaction (within 180 days). The time to complete the transaction cannot be extended and the IRS will not save a 1031 exchange transaction if the intermediary goes bankrupt. The capital gain on the property will be taxed if the bankrupt intermediary does not transfer the replacement property to the seller within the 180-day time period. The seller will be able to claim a loss deduction due to the intermediary’s bankruptcy. The loss deduction cannot be claimed, however, until the bankruptcy case is closed, which results in the seller likely paying the capital gains tax in a year before the write-off is available.
Unintended and simple, honest mistakes have significant adverse consequences. We have worked closely with reputable, qualified intermediaries. We will help you put the right team together that understands 1031 exchange transactions and follows the rules of the IRS Code. This allows you to receive the capital gains benefits that a properly-structured 1031 exchange transaction is meant to deliver.
Heather Brenneman Miles