There are a number of significant income tax benefits that are often overlooked by real estate investors that could allow them to defer or exclude some or all of their income tax liabilities on the sale or disposition of their real estate assets.
It is important for real estate investors to have at least a working knowledge of the basics in order to identify when a strategy may be applicable. The following is a concise summary of the available strategies that an Investor should discuss with his or her tax advisor.
Section 1031–Tax-Deferred Like-Kind Exchange of Property Held for Rental, Investment or Used In a Business
Section 1031 of the Internal Revenue Code (“1031 exchange”) provides that real property held for rental, investment or use in a business (“relinquished property”) can be exchanged for “like-kind” real property also held for rental, investment or use in a business (“replacement property”) allowing the Investor to defer his or her Federal, and in most cases, state income tax liabilities.
It is important to note that 1031 exchange Tax Advisors transactions are tax-deferred exchanges — not tax-free exchanges — as many authors and advisors frequently refer to them. The Investors ‘s capital gain and depreciation recapture tax liabilities are merely deferred — and can be continually and indefinitely deferred — into like-kind replacement properties acquired as part of a series of 1031 exchange transactions.
The tax deferral benefits of the 1031 exchange allow a Investor to sell, dispose or convert real property without reducing his or her cash position by paying capital gain or depreciation recapture taxes. This provides the Investor with the continued liquidity necessary to increase his or her real estate portfolio by trading up in value and ultimately increasing his or her net worth by improving cash flow and capital appreciation from the portfolio.
A Qualified Intermediary is required when completing a 1031 exchange transaction. Section 1031 of the Internal Revenue Code applies to personal property as well as real property.
Section 1033–Involuntary Conversion (Disposition) of Property through Eminent Domain (Condemnation) or Natural Disaster
Section 1033 of the Internal Revenue Code (“1033 Exchange”) provides that real property that is or will be the subject of a compulsorily or involuntary conversion either from an Eminent Domain proceeding (condemnation by local, state or Federal government) or destruction by an act of God such as an earthquake, hurricane, fire, or other natural disaster, in whole or in part, can be exchanged on a tax-deferred basis for “like-kind” real property that is similar or related in service or use to the property that was involuntarily converted.
Owners have up to two (2) years to replace property destroyed due to acts of God and up to three (3) years to replace property converted due to Eminent Domain proceedings.
A Qualified Intermediary is not required when completing a 1033 Exchange transaction.