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 liability on the sale or disposition of their real estate assets.

It is important that real estate investors 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 her tax advisor.

Section 1031–Tax-deferred in-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 (“leased property”) may be exchanged for real property “of the same kind” that is also held for rental, investment, or business use (“replacement property”) that allows the Investor to defer their federal and, in most cases, state tax obligations.

It is important to note that 1031 exchange transactions are tax-deferred exchanges, not tax-free exchanges, as many authors and advisers frequently refer to. Investors’ capital gains and depreciation recovery tax liabilities are simply deferred, and may be deferred continuously and indefinitely, on like-type replacement properties acquired as part of a series of 1031 exchange transactions.

The tax deferral benefits of the 1031 exchange allow an Investor to sell, dispose of, or convert real estate without reducing their cash position by paying capital gains recovery or depreciation taxes. This provides the Investor with the ongoing liquidity needed to grow their real estate portfolio through value trading and ultimately increase their net worth by improving cash flow and portfolio capital appreciation.

A qualified intermediary is required when completing a 1031 exchange transaction. Section 1031 of the Internal Revenue Code applies to both personal and 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 mandatory or involuntary conversion either in an Eminent Domain proceeding (taking 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, may be exchanged tax-deferred for “like” 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.

Section 1034–Reinvestment of Proceeds from the Sale of a Principal Residence (Repealed)

Section 1034 of the Internal Revenue Code (“1034 Exchange”) was repealed and replaced by Section 121 of the Internal Revenue Code. However, it is important to understand what Section 1034 was about, what changed with the repeal of this Section, and what the differences are between the old and new law.

Section 1034 of the Internal Revenue Code allowed an owner of real property used as his or her principal residence to sell or otherwise dispose of the principal residence and defer 100% of his or her capital gains tax liability through the acquisition of another principal residence of equal or greater value.

Qualified Intermediaries were not required for Section 1034 exchange transactions.

Section 721–Tax-deferred exchange of property held for rental, investment, or use in a business in a real estate investment trust (REIT)

Section 721 of the Internal Revenue Code (“721 Exchange”) allows an Investor to exchange rental or investment real property for shares in a Real Estate Investment Trust (REIT). This is called a 721 exchange, also known as an upREIT or 1031/721 exchange.

Investors typically use upREITs in conjunction with the sale of relinquished property and the acquisition of replacement property of the same type pursuant to Section 1031 of the Internal Revenue Code. Once the replacement property has been held as a rental or investment property for 12 to 18 months or longer to demonstrate the Investors’ intent to maintain the property and qualify for 1031 exchange treatment, the replacement property is contributed to a Real Estate Investment Trust (REIT). ) in exchange for shares in the Real Estate Investment Trust (REIT) pursuant to Section 721 of the Internal Revenue Code.

However, the 721 exchange does not have to be in conjunction with a 1031 exchange. The Investor could simply contribute rental or investment properties that the Investor already owns directly to the Real Estate Investment Trust (REIT) as part of a 721 exchange.

The 721 exchange can provide an investor with a great exit strategy when trading their real estate investment portfolio for shares of a Real Estate Investment Trust (REIT) which should provide more liquidity once the Real Estate Investment Trust (REIT) becomes publicly traded and listed on a stock exchange. The Investor also gains complete control and flexibility over capital gains tax recognition by determining the timing and number of shares sold in the Real Estate Investment Trust (REIT).

However, the 721 exchange essentially eliminates the Investor’s ability to re-exchange real property and defer their capital gains taxes through the use of a 1031 exchange because the Investor now owns securities rather than a real estate interest.

Article 121–Exclusion of Capital Gain in the Sale of Principal Residence

The Taxpayer Relief Act of 1997 repealed and replaced the tax deferral provisions contained in Section 1034 of the Internal Revenue Code with a capital gains exclusion provision pursuant to Section 121 of the Internal Revenue Code (“Exclusion 121”).

In general, a Taxpayer may sell real property that they own and use as their primary residence and exclude from gross income up to $250,000 in capital gains tax if the Taxpayer is single and up to $500,000 in capital gains tax if the Taxpayer is married and file a joint income tax return. The Taxpayer is required to have lived in the real property as its principal residence for at least 24 months of the last 60 months (two of the last five years). The 24 months need not be consecutive, and there are certain exceptions to the 24-month requirement when a change in employment, health, or other unforeseen circumstances has occurred.

Section 121 is effective for dispositions of real property held as a principal residence after May 7, 1997. Taxpayers may complete a 121 exclusion once every two (2) years.

Taxpayers should carefully monitor the amount of capital gain “built” on their primary residence and may want to seriously consider selling their primary residence before the capital gain tax liability exceeds the $250,000 or $500,000 limit. The Taxpayer’s capital gains tax liability in excess of these exclusion limitations will be subject to tax. A sale of the primary residence would preserve the tax-free capital gain exclusion and allow the Taxpayer to purchase another primary residence and start over.

Special legal, tax, and financial planning is needed in circumstances where a Taxpayer already has a significant capital gains tax liability that exceeds the $250,000 or $500,000 exclusion limit. For example, the primary residence could become a rental or investment property and then be sold as part of a 1031 exchange after it has been rented long enough to demonstrate the Investor’s intent to maintain the property as a rental property or investment. . This would allow the taxpayer to dispose of their primary residence, defer all capital gains tax liability, and diversify and allocate capital gains tax liability on a pro-rated basis among a number of rental properties, paving the way for more planning. financial, fiscal and patrimonial. opportunities.

There are special rules applicable to real property initially acquired as replacement property through a 1031 exchange transaction and later converted to the Taxpayer’s principal residence and sold pursuant to Section 121 of the Internal Revenue Code.

Consult with Tax and/or Legal Advisors

Investors should always check with their advisors before proceeding with any of these strategies. The sophisticated qualified brokers at 1031 Exchange should also be able to help answer any questions you may have.