This year is the start of a new chapter in pre-construction investments as well as the home-ownership through preconstruction home purchases. The rules that have been set in favor of the real estate investor are still applicable for the post-recession era of real estate transactions. One of these rules in 1031 Exchange, which through that any taxable capital gain on one property could be deferred to another property pending that all the IRS requirements are met.
To simplify this code, any capital gain is taxable unless the capital gain is used to acquire another “like-kind” property. Please note that this is not a forgiveness of the tax amount, but the payment of tax is postponed to a future date. To qualify for 1031 Exchange, there are many guidelines set by IRS which are detrimental in a successful Exchange.
The deferred tax allows investors to have more funds for new investments. This method can help a pre-construction investor to acquire more properties and create a smart real estate portfolio. The following example will demonstrate the mechanism of the 1031 exchange in relation to preconstruction investments as well as a brief summary of some of the rules and timeline.
1031 Exchange Example
There is an investor who purchased a pre-construction unit for $100,000 and currently is in the market to sell the same unit for $120,000. The first step prior to the sale of this unit is to hire the services of a 1031 Exchange Company or as it called a “Qualified Intermediary” or (QI). Since according to regulations the seller could not have possession of the proceeds of the sale at any time, this is crucial to a correctly implementing the exchange.
Upon closing of the sales, the exchange company will hold the proceeds and the seller has no access to that. Seller has 45 days to identify the exchange property or properties and 180 days to complete the transaction. The number and value of the future purchase are set through what is known as three rules that are:
1)- Seller/taxpayer could identify as many properties as he wishes but has to purchase a minimum 95% of the aggregate value of the identified properties.
2) Seller/taxpayer will identify as many properties but could not exceed the 200% or twice the value of the relinquished property.
3) Seller/taxpayer will identify up to 3 properties regardless of the value
During the Qualified Intermediary Company will have the possession of the proceeds and will disburse them only upon closing on the exchange property.
1031 Exchange and Preconstruction Purchases
In case of using 1031 Exchange in pre-construction properties, the seller will sell the unit that he had bought in pre-construction phase through the Qualified Intermediary Company. To take advantage of the deferred tax, he will identify one or number of other properties and close on them on a timely manner. If played by the rules the investor in our example could search for other preconstruction investments that are in the later phases of the construction that he could close within 180 days of the exchange period. In this case the investor had benefited from the gain on the first pre-construction purchase, without paying the capital gain tax on capital gain and used the gain plus the deferred taxes to buy one or more pre-construction units with a chance of another gain during the future sales.
The 1031 Exchange as other tax related transactions shall only be handled by authorized firms and individuals. The author is not a QI or a tax accountant and as a real estate broker shares the experience that he had gained through his involvement with the sales and purchase of exchange qualified properties. For tax benefits and the latest updates on the 1031 exchange code, please contact professionals who are authorized to assist you to benefit from this great tax deferment strategy. We also found the website for 1031.org extremely helpful and the FAQ section of the website a perfect source to gather useful information.