The tax consequences of trading spaces are fairly painless if you participate in an Internal Revenue Code Section 1031 tax deferred exchange. Such exchanges allow the seller to defer taxable gain on investment properties. Key to this concept is that taxes are deferred which means, of course, that at some point they must be paid.
Play by the Rules
While specific rules are a quick “Google” or “Yahoo” search away, my “go-to gal” is Julie Bratton of Old Republic Exchange. During our recent Real Estate Wine’d Down, Julie reminded us of critical steps and suggestions which aren’t necessarily part of any published guidelines. Your purchase agreement is one of the first places an exchange can get into trouble. In order to comply with IRS requirements, specific language indicating both parties agree to participate must be included, or the exchange could be disqualified. A simple recitation of the agreement will suffice. But expanded language is required to fully protect the seller, especially on the buying “leg” of the exchange. Remember, an exchange must be like-kind for like-kind which simply means real estate for real estate; land for house, house for condo, etc.
Time is Ticking
Julie reminded us that there are strict time limits (45 days to designate and 180 days to close) related to the exchange. It is a good idea to designate multiple exchange properties. Hawai`i is infamous for title and survey problems. Delays in resolving these could easily extend closing beyond the allowable time.
Tip: Check property titles early.
As part of previous conversations, Julie reminded me that transactions with foreigners can be quirky. The IRS requires that all foreigners involved in real property transactions must have a Tax ID number. They should apply early because a delay could cause the process to exceed the allowable timelines. Remember, key to every exchange is the concept of “control of funds”. The party relinquishing the funds (the seller, then buyer) is not allowed to touch either proceeds of the sale (the first leg) or funds being held to complete the purchase (the second leg). An Exchange Accommodator must be used.
Tip: Exchange accommodators are not regulated in Hawai`i, so choose your third party intermediary carefully.
Keep in Mind
Even though taxes are deferred, it is widely held that an investment property may be converted to personal use after a period of investment use. Investment use for one to two years is probably fine but as Julie reminded us, the taxes on previous sales is still due. Death moves the tax basis (the taxable amount) forward to the date of death. For this reason, Julie recommends that heirs consider selling at that time. Otherwise future appreciation will be fully taxed.
Tip: Most exchanges are fairly straight forward but it’s always advisable to consult a financial advisor and an attorney versed in exchanges. Not all are!
Remember, builders of spec homes are dealers. Such sales do not qualify for tax deferred exchanges.
Tip: When it comes time for your next exchange, use a Realtor® who understands the basics especially as relates to our Hawai`i market!
Quick reminder, join us online for our next Real Estate Wine’d Down. Just email me for an invite!