Central Park New York Casas Office

Tax deferred exchanges for foreign nationals buying property in the U.S.

//What is a 1031 exchange?

Thanks to IRC Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

//What are 1031 Tax Deferred Exchanges & How Do They Work?

In a “1031 exchange” an asset – typically real estate – is sold and the proceeds are then reinvested in a “like kind” asset. By conducting this exchange, the individual will not recognize any losses or gains as per Section 1031 of the Internal Revenue Code. Capital gains taxes are deferred until property is sold and not exchanged.

The exchanged property must be identified within 45 days. All proceeds of the initial sale must be re-invested in the like kind property within 180 days of that sale. When exchanging property, you must do so if like kind. Real property has to be exchanged with real property, not personal property.

1031 Exchanges can only take place with investment property, commercial property, personal property or trade property (no personal residences). Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets. Qualified Intermediaries exist to help individuals and businesses execute 1031 exchanges of all types.

//1031 Exchange Examples

An investor that decides to sell a property for $1,000,000 that he purchased 5 years ago for $600,000 incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. If he invests the $1,000,000 in another investment property anywhere within the United States through a 1031 exchange, he will defer paying capital gains taxes on this transaction after the sale.

If the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.

As the above example demonstrates, 1031 exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the Section 1031 code. For instance, an accurate understanding of the key term like-kind – often mistakenly thought to mean the same exact types of property – can reveal possibilities that might have been dismissed or overlooked.

Another example would be: An investor has a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another property.

New York Casas would appreciate the opportunity to work with you on your next 1031 exchange regardless of how simple or complex You can contact us here.

//What are the benefits of a Section 1031 tax deferred exchange?

1031 tax deferred exchanges allow real estate investors to defer capital gain taxes on the sale of a property held for productive use in trade or business or for investment. This tax savings provides many benefits including the obvious – 100% preservation of equity. Investors can take advantage of exchanges to meet other objectives including: A) Leverage: exchanging from a high equity position or “free and clear” property into a much larger property with some financing in order to increase their return on investment. B) Diversification: Such as exchanging into other geographical regions or diversifying by property type such as exchanging from several residential units into a retail strip center. C) Management Relief: for example, exchanging out of multiple relinquished properties into either a replacement property like an apartment complex with an on-site manager or a tenant-in-common ownership program.

//What kind of property can be exchanged and what is the definition of like-kind property?

Any property held for productive use of trade or business or for investment can be exchanged for any other property held for productive use in trade or business or for investment – these properties are considered “like-kind” to one another. Examples of like-kind investment real estate include: exchanging unimproved for improved property; a fee interest for a leasehold with 30 or more years left; exchanging vacant raw land for a commercial building; or exchanging a single-family rental for a small apartment complex. The rules for exchanges of personal property are significantly narrower and class or asset code specific than for real property.

//How long does a property need to be held for investment?

The central issue is whether or not the investor has the intent to “hold for investment”, not just the period of time. There is no “safe” holding period to automatically qualify as being held for investment. Time is only one of the factors the IRS can look at to determine the exchanger’s intent for both the relinquished and replacement properties. Every investor has unique facts and circumstances and it is up to them, and their tax or legal advisors, to be able to substantiate that their primary intent was to hold property for investment purposes.

//Is it possible to exchange an LLC member interest or a partnership interest?

No, an LLC member interest, where the LLC elects to be treated as a partnership, or a partnership interest are considered personal property and cannot be exchanged. IRC Section 1031(a)(2)(D) specifically prohibits the exchange of partnership interests. However, both an LLC or partnership (or any other entity for that matter) can do a 1031 exchange on the entity level, meaning the entire partnership relinquishes a property and the entire partnerships stays intact and purchases a replacement property. If you are in a situation where some LLC members or some partners would like to exchange, but others don’t, consult with your tax or legal advisors and discuss the issues involved with strategies and the timing of performing what are known as “drop and swap” or a “swap and drop” alternatives. In a community property states only, a husband and wife who are the sole members of a two-member LLC may be considered a single member disregarded LLC for Federal tax purposes – check with your tax or legal advisors to discuss this more thoroughly.

//1031 exchange checklist

This 1031 exchange checklist is intended to provide a brief overview of the steps involved in an IRC Section 1031 tax-deferred exchange. This checklist does not address all issues involved in an exchange.

  1. REVIEW: Review the entire transaction with tax and/or legal advisors.
  2. Open a New 1031 Exchange online
  3. SALE CONTRACT: Enter into an “assignable” contract to sell the relinquished property. Execute contract with the exchanger’s name and/or assigns, and with language recognizing the exchange, with the other party’s consent.
  4. RELINQUISHED PROPERTY CLOSES: New York Casas is assigned into the transaction as the seller and sale closes. Pursuant to the assignment agreement and exchange documents, New York Casas instructs the closing officer to directly deed the relinquished property to the buyer or Exchange proceeds are transferred directly to New York Casas via wire transfer.
  5. IDENTIFICATION PERIOD: Both the 45-day identification period and exchange period begin. Although it is the sole responsibility of the exchanger to meet all identification rules, New York Casas will forward confirmation of the exchange proceeds received, the timelines for the 45-day identification period and 180-day exchange period (or the date the tax return is due, whichever is earlier) exchange period, the identification requirements and the identification rules.
  6. PROPERTY IDENTIFIED: Exchanger properly identifies replacement property by midnight of the 45th day.
    A) Specific written identification, signed by the taxpayer, is forwarded to New York Casas.
    B) Written identification can also be made to a party involved in the exchange transaction who is not a disqualified person.
    See the IRS Treasury Regulations for more details on the identification requirements.
  7. PURCHASE CONTRACT: Enter into an “assignable” contract to purchase replacement property. Execute contract with the exchanger’s name and/or assigns, and with language recognizing the exchange, with the other party’s consent.
  8. A) Call your Exchange Counselor at the National Headquarters or Eastern Regional Office – or –
    B) Open a New 1031 Exchange online, Purchase of Replacement Property.
  9. EXCHANGE PAPERWORK PREPARED: New York Casas will prepare the exchange documents for purchase.
    A) The original documents will be forwarded to the closing officer who will coordinate the signatures.
    B) Copies of documents are forwarded to the exchanger.
  10. Replacement property closes.
  11. COMPLETION: If all exchange funds are used to acquire the replacement property or properties, and all the exchange requirements are met, the exchange is complete.