Like Kind ExchangeIf you’ve heard of this terminology before then you either have investment properties, or are considering them as additional revenue. A like kind exchange is process created for real estate investors to mitigate tax liability.As a real estate investor, you are required to pay taxes on your property sales, as this is viewed as income. This can become quite costly, especially if you want to keep reinvesting your money into real estate. That is where like kind exchange, also known as a 1031 tax-deferred exchange, comes into play. The textbook definition of this exchange is for two property owners to exchange a deed, however that rarely happens in the market today.A more realistic application of the exchange is to find another suitable investment property within an allotted period time, after selling your current investment property, in which the funds will be allocated to.However, US tax laws have very strict perimeters, regulations, and timelines that need to be followed in order to qualify for the tax-deferral. Read on for a step by step analysis of the transaction, with emphasis on the necessary regulating points.
Qualifying for like kind exchangeIn order to qualify for 1031 tax-deferred exchange, the properties must be used for trade, business, or investment purposes. (This is not going to be your family home). While the exchange has to make sense, it does not have to be an identical property or exchange. That means that an office complex (business) can be exchanged for a family rental property (investment), rural land (trade), retail space (business), or even an industrial space (business/trade). Once you have identified that your property qualifies for an exchange, follow this step by step guide to get an understanding of the process.
The first step.Enter into a purchase/sale agreement with a buyer for your property. In this contract you should have a cooperation clause which identifies and assigns a qualified intermediary for the funds.
What is a qualified intermediary?
A Qualified Intermediary is a person or company who is not the tax payer, or any of the disqualified persons, that is in the business of facilitating like kind exchanges. They are positioned to handle all funds and transfers from from the sale and purchase of investment properties.
US real-estate tax law states that it is crucial for the funds to go to a qualified intermediary for the exchange process. If the seller is ever in receipt of the cash, even constructively, the tax-deferred exchange will be terminated immediately. This cancels out any family or relatives from receiving the funds, or any broker, agent, accountant, or attorney that you have worked with in the past two years.
The second step.
Like Kind Exchange Documentation. Your qualified intermediary should help you with the forms, agreement, and contract to ensure that everything is filled out properly and filed in a timely manner.
The third step.
Property closing. The buyer will take over your property, and the proceeds should be transferred directly to your qualified intermediary. Again if the client is ever in receipt of the funds, they will lose the tax-deferral. Its better you use our link kind exchange calculator to facilitate your capital gains tax.
The fourth step.
Perhaps the most important perimeter: Identify a Replacement Property within 45 days. The necessary forms should be provided to identify a replacement property and should strictly adhere to the timeline. 45 calendar days. Not business days. No holiday or weekend exceptions or extensions. If you miss this, you have blown your opportunity for tax-deferral.
It is also extremely important to have at least 3 replacement property options, incase anything happens and a deal falls through you have a back up. In the event that you only provide one replacement property and it falls through with no subsequent replacement within the 45 day time line, you lose your tax deferral.Unfortunately real estate transactions and deals fall apart for a multitude of reasons, quite often. My husband is a broker and real state investment syndicator, so I see time and time again the nuances that derail even the most straight forward deals. Believe it or not one of his clients lost three consecutive deals- all for different reasons. One deal was lost because of hidden fees that his lawyer missed in the contract, only upon closing were the hidden fees realized which forced the client to back out and lose his deposit. The second was lost because of a simple miscommunication with an underwriter. This miscommunication prevented him from attaining funds needed to close the deal, as it was over the holidays so he was unable to find a timely substitute. Finally the third was lost because he took a verbal agreement for an extension on closing, which he needed in order to produce his required documentation (procrastination on his part). However because it was never in writing the seller backed out on the closing date, again resulting in a lost deposit and lost deal. All of these circumstances, all of different origin- some within the clients control, others not- cost the client thousands of dollars. This is an extreme case, but if you even find yourself in one of these situations you will be thankful to have the other back up properties.
br>The fifth step.
br>Replacement property purchase contract. This should also include a cooperation clause as the funds will be dispersed by your intermediary.
br>The sixth step.
br>Like Kind Exchange documentation. Similar to the second step, only towards the replacement property. Again your intermediary should guide you through the forms and agreements to ensure that they are filled out properly and filed on time.
br>The seventh step.
br>Property Closing within 180 days. The closing date must be within 180 of the closing of the original exchange property, or the due date of the tax return, or again, the client risks losing their tax-deferral. That is why our like kind exchange calculator can make this decision much safer for you.
br>The final step!
br>Completion forms. The final step is to complete all the exchange documents which require proof of fund transfer and and receipt of the new property.
br>Finally, it has been stated by several US Court cases that you must occupy the property for at least two years (two tax return cycles) in order not to incur any penalties.
br>For a savvy investor and well educated accountant, it gets a bit more complicated with multi-assets, and mixed-use exchanges, as well as reverse exchanges, however that may be a post for another day. Happy investing!