FYI: 1031 Like-Kind Exchanges
Complex real estate transactions are not just for bold-faced names. Freelancers, small business owners, and the self-employed can benefit from the opportunity provided by Federal tax law to put off paying capital gains tax. If you sell non-residential property and buy property of a "like kind", you may be eligible to defer, perhaps indefinitely, some or all of your capital gains tax. Complicated? A little. Esoteric? Very. Irrelevant! Maybe not.
What's capital gains tax?
When property is sold, the amount by which the selling price exceeds the original purchase price (minus certain expenses like closing costs and capital improvements) is profit or, in tax language, "capital gain." Capital gains are taxable by the Federal government and by some state governments as well, though capital gains tax rates are lower than ordinary income rates. Capital gains can only be offset by capital losses, however, so even if you aren't liable for taxes on your regular income, you may have to pay capital gains tax.
The law treats residential and non-residential property differently. Federal tax law provides an exemption for profits on the sale of residential property, $ 250,000.00 for single tax-payers, $ 500,000.00 for married taxpayers filing jointly. But there is no exemption for profits from the sale of non-residential property. Here's where the 1031 exchange comes in.
How does it work?
The law requires a "qualified intermediary" (QI) to hold the proceeds of the sale of the "relinquished property" until a "like kind" property ("replacement property") is purchased. Three possible such properties must be identified within 45 days of the sale, and the purchase must be completed ("closed") within 180 days. The QI then completes the purchase by releasing the proceeds of the sale for the sole purpose of buying the replacement property. In other words, the third party takes the profits and holds them for the purchase. The process is straight-forward, cost effective because the QI does all the work and charges only a modest fee, and the tax saving can be substantial.
Of course, there are more complex transactions in which only a portion of the profits can be attributable to non-residential property, or when the profits exceed the price of the replacement property, or even when the exchange is done in reverse and the purchase of the replacement property comes before the sale of the relinquished property.
How could this possibly
be relevant to me?
Assuming you are an owner not a renter, if you run your business out of your residence or if you have a home office, you may be eligible for a 1031 exchange when you sell. That portion of your residence used for non-residential purposes can be exchanged for a "like-kind" property, even if the replacement property is only partially used for non-residential purposes. For example, if your ballet studio is in your basement (one-third of the total square footage of your house), one-third of the profits may be sheltered from capital gains tax when you buy a larger house, so long as at least one-third of the replacement property (the larger house) is dedicated to the non-residential purpose. The same applies to a legitimate home office, or a rental unit. Which means that anyone who works from home may be eligible for a 1031 exchange!
If you own now, or if you plan to own, speak to your attorney or your accountant about how you might benefit by a 1031 exchange. You don't have to be a real estate tycoon.