Section 1031 of the US tax code allows the deference of capital gains from the re-exchange of similar properties. The IRS had determined strict rules and conditions to prevent the abuse of this section. It is therefore best to use a qualified intermediary whose role is to prevent disruptions to the process.
Section 1031 determines that a property used for generating income for a business, or a property used for investment, can be re-exchanged for a similar property and does not constitute a tax event. A similar property refers to the nature of the property rather than its façade. In this manner, an apartment can be exchanged for a villa, land can be exchanged for an apartment, etc. a property in the US and a property outside the US are not similar, but US citizens can re-exchange a property outside the US with a property in the US. Additionally, there is no limit to the number of assets that can be acquired in such a process. The possibilities are plentiful, but the new property must also be used for business, investment or generation of income. The section does not refer to an individual dealing in the sale of properties (where properties are considered inventory), nor residential assets, apart from vacation properties.
How does it work?
After closing the sale and the contract for the first property, the investor has 45 days to identify at least 3 properties they wish to purchase in their place. The new property(ies) must be closed off on up to 180 days after selling the previous property. It is important to understand that in order to take advantage of the fullest potential of the deferral, one must choose properties of equal or greater value than the sold property.
The process is done with a certified intermediary and a trust account in order to be legitimate. For this reason, investors have no interaction with the money during the sale and purchase. From the moment of sale the property is placed in a trust, from which it is used to purchase the desired property.
Numeric example:
A owns a property that for the past two years has been used for rental. A thinks about selling the property and wishes to defer the capital gain. A bought the property for $100,000 and over those two years requested a depreciation of $20,000. A’s depreciated value is $80,000. A sells the property for $120,000 and instead buys a property for $140,000. What is the book-value of A’s new property?
$140,000 – $40,000 = $100,000
Refer to the chapter on Israeli taxation in order to examine the viability of such a process.
In the event of a re-exchange, you can request an exemption from FIRPTA by filing form 8288-B.
The whole idea of a 1031 exchange transaction is that the investor relinquishes control of the transaction over to intermediaries and does not come into contact with the money. Changing your mind is possible at very specific times: before the sale of the first asset, after 45 days, after the purchase of the new property(ies) and after 180 days.
