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The Tax Prophet Newsletter   Issue # 26 August, 2005

REDUCE TAXES!
CHECK OUT THE TAX PROPHET'S Action Guides


In This Issue:
Deferred Exchange
Constructive Receipt
Related Party Transactions
Conclusion


Tax Free Exchanges
Part 2 of 2


Deferred Exchange

Section 1031 allows for a deferred exchange (i.e. you transfer your property first and then later receive replacement property). These exchanges are often complicated and have strict deadlines. You only have 45 days from the close of escrow to identify replacement property and completion of the exchange must occur within 180 days from the close of escrow (or if the exchange occurs late in the tax year, the due date for your tax return, plus extensions).

Section 1031 requires an intent to exchange one property for another (called contractual interdependence). Also, the taxpayer cannot receive sales proceeds. Because of constructive receipt concerns (discussed below), a neutral and independent intermediary is usually necessary to hold the proceeds while the exchange is being completed.


Constructive Receipt

Unfortunately, taxpayers might "constructively" receive cash, thereby destroying their chances for a successful tax-free exchange. Any cash received or net relief of indebtedness on the transferred property falls outside IRC Sec. 1031, causing a taxable transaction as to those amounts. Also, if you sell property and then purchase a replacement property with cash, IRC Sec. 1031 will not apply -- so be careful!

You constructively receive cash when you have the right to obtain the cash (or the benefit of the cash) without substantial restrictions. For instance, money left in escrow, but available to you, constitutes constructive receipt. The same is true if a check is issued, but you decide not to cash it.


Related Party Transactions

Sec. 1031(f) restricts exchanges between related parties. For example, if you exchange property with your mother and she sells the property within two years, the original exchange transaction will be considered a sale by you and not an exchange between you and your mother.

To illustrate, suppose your property has a $100,000 gain and you exchange it for property held by your mother. If your mother sells the property acquired from you within two years, the transaction will be considered a sale by you of your original property and you'll pay tax on the gain. Once the two-year period under IRC Sec. 1031(f) expires, a sale by your mother will result in a taxable transaction to her, not to you.


Conclusion

When used correctly, Sec. 1031 provides real estate investors with a powerful tool to continuously acquire larger, more expensive properties without the imposition of income tax. The key is finding suitable replacement property and then making sure you comply with the deferred exchange provisions to avoid actual or constructive receipt of the cash.



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All contents copyright © 1995-2005 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.