Capital gains taxes can take a chunk out of the proceeds from an investment property sale – sometimes upward of 30% when federal and state taxes are combined. A 1031 tax deferred exchange is one way to defer paying capital gains taxes on real estate investments, but it comes with requirements that, if not met, will invalidate the deferment.
The process is generally simple. Once you sell a property, you have 180 days to reinvest the gain into another property. You must identify within the first 45 days after the sale of the “relinquished property” the “replacement property.” This is done using a “qualified intermediary” (QI) to keep track of your exchange and hold and disburse your funds. The closing on the replacement property must occur within the next 135 days. These are the general rules, but, as with all provisions of the tax code, a multitude of exceptions, qualifications and conditions apply. For example, many do not realize that the tax code provides that the replacement property must be purchased by the earlier of:
- 180 days after the date the sale of the relinquished property, OR
- *The due date of the taxpayer’s return for the taxable year in which the relinquished property closing occurs.
For example, assume you sell property on December 1, 2022. Identification of a replacement property must be done by January 14, 2023 (i.e., the 45-day identification period). Since the due date of the taxpayer’s return is April 17, 2023, that would be the deadline to complete the 1031 exchange. April 17 is 43 calendar days earlier than the 180-day typical period. To get the full 180-day period, the taxpayer must file an extension for the entire tax return, which would give them until May 29, 2023, to close on the property – the full 180 days.
We advise working with your advisor to accurately calculate the value of your reinvestment. These issues require careful planning and consideration when using a 1031 exchange as part of an investment transaction – particularly if part of a syndicate or TIC arrangement.
Lastly, in a deal with multiple partners, coordination between the various QIs, investor accountants and their counsel are essential to a smooth closing. Partners frequently have separate issues and interests, and it is important that those issues are adequately addressed.
Next month’s article will focus on Tenant-in-Common agreements: one of the primary legal vehicles utilized by those seeking to invest in property together.
* You must consult with your tax advisor regarding your tax filing requirement dates.
