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 sellers to defer taxable gain on investment properties. The key to this concept is that taxes are deferred which means, of course, that at some point, they must be paid. While specific rules are but a quick “Google” or “Yahoo” search away, there are critical reminders and suggestions which aren’t part of any published guidelines.
Your purchase agreement is one of the first places an exchange can get into trouble. It’s fairly common for me to receive offers on my listings without the required language. In order to comply with IRS requirements, specific language indicating both parties agree to participate must be included in the purchase agreement or the exchange could be disqualified by the Internal Revenue Service. This could be a very expensive omission if the exchange is later ruled invalid. 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 stated means real estate for real estate; land for house, house for condo, etc, etc.
A second caution which thwarts many local buyers and sellers involves foreigners. The IRS now requires all foreigners involved in real property transactions to have a Tax ID number. Because there are strict time limits (45 days to designate and 180 days to close) related to the exchange, a foreigner involved in a tax deferred exchange could cause the process to exceed the allowable timelines. It’s wise to ensure a foreign participant applies for a tax ID number early on. It’s also a good idea to designate multiple exchange properties. Because of the number of title and survey problems in this State, delays in resolving these could also extend closing beyond the allowable time. Be very careful when designating REO or short sale properties. Title or short sale approval delays could result in a failed exchange.
Remember, the 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. Exchange accommodators are not regulated in Hawaii, so choose your third party intermediary carefully. 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. Anything less might disqualify the exchange, resulting in tax consequences of up to 20% (in Hawaii). Most exchanges are fairly straightforward, but it’s always advisable to consult our financial advisor as well as an attorney versed in such exchanges. Remember, builders of spec homes are dealers. Such sales do not qualify for 1031 tax deferred exchanges. When it comes time for your next exchange remember to use a Realtor® who understands the basics, especially as related to our Hawaii market!
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Hilo, HI Real Estate
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