A common tool for real estate investors, the 1031 Tax Deferred Exchange allows the investor to defer capital gains taxes on their investment properties if those gains are “re-invested” into a “like-kind” property. This is a wealth-building tool that ultimately gives you 15-35% more cash to put towards your next investment. This tax deferral is what allows investors to build bigger and bigger portfolios.

The 1031 Exchange is not a tax avoidance mechanism, rather it is a way to defer tax on your gains until you eventually sell or downsize your investment portfolio. When used correctly, it is an excellent mechanism to keep your money growing out of the reach of Uncle Sam.

The Code

Internal Revenue Code (IRC) Section 1031 – allows an owner of property held for productive use in a trade or business, or for investment, to defer payment of taxes on gain realized in the sale if they exchange for like-kind property. The tax is deferred (but not avoided) by transferring the basis in the relinquished property to the replacement property.

The Basics

Again, this is a tax benefit for investors only – and the exchange cannot be used for properties you intend to live in. Two categories of property qualify for exchange treatment:

• Property held for investment, or
• Property held for productive use in trade or business

Examples include:

• Commercial property, such as office, manufacturing, rental
• Vacant land
• Apartment buildings, duplex/triplex/fourplex, rental homes
• Mixed use (investment & personal use)
• Agricultural land

NON-Qualifying properties include:

• Property held for personal use – this may include a second home or vacation property
• Property held primarily for sale – for instance a rehab or “flip” property

How it Works:

1. First step – You should speak to your tax or legal advisor to understand the benefits as they relate to your specific circumstance. This is not a strategy you want to goof up, as the tax consequences can be severe.
2. Consult a 1031 Exchange Company – you will want to have them on board to facilitate the transaction and they can work hand-in-hand with escrow.
3. Start looking at exchange properties. Given the very short timeframe of an exchange, you will need to start shopping exchange properties as early as possible. You don’t want to sell your investment and then run out of time to find its replacement, as you’ll be stuck with a fully taxable event.
4. Understand the three basic rules, or risk paying capital gains taxes:
   • Use all the cash in the exchange account to acquire the replacement property
   • Have equal or greater debt on the replacement property
   • Purchase only like-kind properties
5. You must have exchange documents drawn up PRIOR TO CLOSING the sale of the relinquished property – or the sale will be fully taxable.
6. Your exchange funds can only be used to pay for:
   • Earnest money deposits for replacement property
   • Replacement property
   • All typical and ordinary closing costs (although there may be rules about using funds for appraisals and loan fees – check with your exchange facilitator.)
7. There are set timelines that must be adhered to. The clock starts ticking the date the relinquished property closes with the new buyer.
   • 45 day rule – the Exchanger must identify the potential replacement property(s) within the first 45 days.
   • 180 day rule – the Exchanger must acquire the replacement property within this period of time. (This timeframe could be shortened if your tax return is due within this time span.)
8. There are some very specific rules around identifying your “replacement properties” – with both how many to select and how to select them.
9. Keep all your records and consult a CPA at tax time. This is not like buying your house, where you toss your closing documents in a drawer and forget about them. Accurate record keeping is essential to maintain your tax-deferred status, and tax return preparation becomes non-trivial when you start introducing 1031 Exchanges into the mix.

It’s best to consult your real estate agent or 1031 Exchange Facilitator with specific questions. We recommend Exchange Facilitators or Investment Property Exchange Services as trusted Exchange companies.

There are several special tax deductions and credits available to purchasers of homes in 2010, along with other deductions that remain available for homeowners.

First-Time Homebuyer Credit

A credit of up to $8,000 is available for homes purchased before May 1, 2010. The credit is also available to purchases of homes completed by October 1, 2010 if the purchaser and seller enter into a written binding contract for the home before May 1, 2010, to close before July 2, 2010.

Calling this credit the “First-Time Homebuyer Credit” is a little misleading. The credit is available to purchasers who have had no ownership interest in a principal residence at any time during the three-year period ending on the date of the purchase. In addition, purchasers who have had an ownership interest in a principal residence for a five-consecutive-year period during the eight-year period ending on the date of the purchase can qualify for a reduced credit of up to $6,500. In either case, the purchased home must be used as a principal residence.

The credit is claimed on Form 5405, Fist-Time Homebuyer Credit and Repayment of the Credit. In order to claim this credit, one of the following documents must be attached to the 2010 tax return:

• A copy of the settlement statement showing all parties’ names and signatures, property address, sales price, and date of purchase. Typically, a copy of the Form HUD-1, Settlement Statement, is used.
• If a mobile home is purchased and a settlement statement is not available, a copy of the executed retail sales contract showing all parties’ names and signatures, property address, purchase price and date of purchase may be used.
• If a newly constructed home is purchased and a settlement statement is similarly not available, a copy of the certificate of occupancy showing the owner’s name, property address and date of the certificate may be used.

Qualified Residence Interest Deduction

Interest paid on acquisition or home equity indebtedness is deductible as an itemized deduction. Acquisition indebtedness includes all debt incurred to acquire, construct, or substantially improve a qualified residence so long as the debt is secured by the residence. Home equity indebtedness includes any other debt secured by the residence, so long as it does not exceed the fair value of the residence reduced by any acquisition indebtedness. The interest on up to $1 million of acquisition indebtedness plus up to $100,000 of home equity indebtedness may be deducted.

Mortgage Insurance Premiums

Premiums on mortgage insurance provided by the Veterans Administration, the Federal Housing Administration, the Rural Housing Administration, and private mortgage insurance paid for 2010 are deductible as qualified residence interest. If premiums are prepaid for the term of the loan, the portion allocable to 2010 may be deducted.

Points

Points paid on a loan for the purchase or improvement of, and secured by, a principal residence are also deductible as mortgage interest in the year paid. “Points” include amounts designated as “loan origination fees”, “loan discount”, “discount points”, or “points” which are calculated as a percentage of the loan amount so long as these amounts are not paid from loan proceeds.

Real Estate Taxes

Real estate taxes paid during 2010 are deductible as an itemized deduction. In addition to amounts paid directly by the home owner or from a mortgage escrow account, amounts charged to the buyer through the apportionment of real property tax on sale (listed on the HUD-1 form) are also deductible.

About Colin Cary

Colin has over 22 years of experience in public accounting, primarily in the area of taxation. Colin graduated from Seattle Pacific University in 1988 with a B.A. in Accounting, Finance and Computer Science. He joined Smith Bunday Berman Britton in September 2000 and has extensive experience with closely-held corporations and their shareholders, including transactional planning between corporations, shareholders and related corporations, corporate and individual tax return preparation (including complex consolidated corporate returns), representation of corporations and related shareholders before federal and state tax agencies, and planning related to corporate acquisitions, reorganizations, liquidations, debt restructuring (including issues related to net operating loss limitations and utilization), and employee compensation arrangements. Colin is a member of the American Institute of Certified Public Accountants and the Washington Society of Certified Public Accountants.

It is easy to see the logic in some of the legislation that lead us to the current state of chaos. Legislators propose a variety of laws that encourage certain business activities and penalize others. The problem is that there is little or no regard for the practical implications of their decisions when tax time rolls around. President Obama seems to agree in his statements today. Hopefully that will translate into action.

President Obama promised to begin work to simply what he described as "a monstrous tax code" that is "far too complicated for most Americans to understand, but just complicated enough for the insiders who know how to game the system."

I did have a pleasant surprise this year and was a direct beneficiary of Obama’s small business stimulus. As a startup company, we invested a significant amount to get things rolling last year. That generated an operating loss which I could roll back to previous years and gain a tax refund. Sounds great, right? Monetarily it is, but the logistics of filing for the refund with Form 1045 descend into the deep, dark nether regions of the IRS tax code. Not only was my CPA confused by the incomplete documentation, but the IRS representative in the “complex issues department” couldn’t even explain it correctly. It simply doesn’t have to be this difficult.

While easy to fault the IRS, this complexity spills down to the local level in even more insidious ways. Here in Seattle, businesses pay a Business & Occupation Tax (B&O) in addition to our state B&O tax. It is neat and tidy if all of your goods and services are sold in Seattle, but if you venture outside the city limits, you need to break up your sales by city and then pay them a tax based on the square footage of your office, of all things. The forms and methods for calculating this tax make the IRS forms look simple!

There was a day when taxation was much simpler, but that day seems to have passed us by. Hopefully initiatives from the Obama administration are able to make progress here, and hopefully that progress trickles down to the local level. However, that trickle will be slow as we seem to have embraced a culture of legislating taxes to stimulate or cool the economy for each micro-sector. I’m sure small business owners would rejoice if all of this could be simplified so that they can focus on what really matters, which is building their own businesses.