Section 1031 of the internal revenue code provides the flexibility to the investors in the real estate sector in the United States to defer the capital gains taxes earned by selling properties. The section is applicable on investment properties and states that capital gains made out of sale of a property may be deferred if the proceeds from the sale are invested in another “like-kind” property.
To understand the concession extended by section 1031, it is important to have a clear understanding of the following:
• Like-Kind property
• Time lag between sale and reinvestment
• Parking of sale proceeds before being reinvested
Like any other tax benefit extended to investors, it is essential to comply with certain conditions to enjoy the benefits. Firstly, the reinvestment of funds in a like-kind property must happen within a time period of 45 days of the closure of sale of the property. A like-kind property is any property which is physically located in the United States and may be improved or unimproved property compared to the one that is sold. The second condition that needs to be fulfilled is the compliance of rules with respect to making use of a qualified intermediary. A qualified intermediary is a middle man who holds the proceeds from the sale and it could be a person or a company. It is only to the extent of funds parked by the seller with the qualified intermediary that the deferment on capital gains taxes is allowed. The qualified intermediary makes use of an escrow account to hold the funds till they are reinvested in a new property. The latest amendments to section 1031 include that the loan amount arranged for the reinvested property must be higher than the loan availed on the sold property.
Let us work with a few numbers to illustrate the section 1031 better. Assume an investor in the real estate space who sells a residential property for USD 600,000. The property was purchased by the investor for an amount of USD 450,000. This implies he makes a gain of USD 150,000. In accordance with the capital gains laws, he shall have to pay a capital gains tax on this amount of USD 150,000. However, if he utilizes the flexibility provided by section 1031 and reinvests these funds in a new property, he would be allowed to defer the payment of capital gains. The investor however has to ensure compliance to the rules discussed above.
At times it is difficult to comply with all the necessary rules applicable for section 1031 to avail tax concessions. The investors find it difficult to adhere to the norm of 45 days within which the funds have to be re-invested. This difficulty can be overcome provided the investor makes an early search to identify and select a property for reinvestment and closes transaction related to sale and purchase within a short span of time. The IRC does a strict check before allowing the tax benefits and does not grant any leniency when it comes to benefits of section 1031.
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