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Exchange Now Pay Later

If you're selling an income-generating property and buying another property with the proceeds, you might want to consider using what's commonly referred to as a 1031 exchange. Under IRS Section Code 1031, you can defer paying capital-gains tax on the sale of your property.

The code only applies to the sale of property defined as commercial or business properties. In short, any property where the property itself makes you money. (An apartment where you hawk Beanie Babies on eBay does not suffice.)

For instance, let's say you sell a one-bedroom apartment in Chelsea, an apartment you've been renting out. If you sell the place for $1 million, you can turn around and purchase what the IRS defines as a "like-kind property" with the proceeds, but defer paying capital-gains tax on the sale.

That "like-kind" property is any other income-generating property, so it could be another rental unit, a pizza parlor or a hair salon, for instance. The benefit behind the 1031 exchange is that "it allows the investor to use the full appreciation of the sale to buy something else," says Frank Gerage, a former managing director at Manhattan Apartments. "It's a phenomenal tool." ,br>
Understanding the 1031

There are stipulations with 1031 exchanges, the biggest one being time. You only have 45 days from the date you go into contract to formally identify the property you intend to buy, and just 180 days from the initial contract date to close on the new property. Additionally, the value of the property you are buying must be of equal to or greater value to the property sold. The mortgage of the new property also must be of equal or greater value of the old mortgage.

And all of the proceeds from the sale of the relinquished property must be used to acquire your replacement property.

If the stipulations are not followed, IRS penalties can occur. While sophisticated investors have long known about 1031 exchanges, experts say it is only now becoming more popular, as individual investors learn about the code.

Jacky Teplitzky, vice president at Prudential Douglas Elliman, says that half the real-estate deals she works on now use the 1031 exchange. Teplitzky is currently helping a client sell a Manhattan townhouse and invest in either a shopping center or a retirement home in Florida (1031 exchanges can be used to purchase a like-kind property anywhere in the country).

Of course, Teplitzky's client will one day have to pay the tax on the sale of that townhouse, unless he keeps reinvesting or re-financing. By deferring, the client is just simply pushing back the deadline of paying.

But the best use of a 1031 exchange is from an estate planning point of view, notes Manhattan Apartments' Gerage. If you leave your property to your heirs, they don't have to pay the rolled-over capital-gains tax.

"If you die, the tax liability is buried with you," Gerage says.

Finally, a qualified intermediary must handle the sale of the 1031 exchange. Most charge $600 to $1,500 to handle the transaction, according to Esther Silberberg, head of operations at Madison Exchange, a qualified intermediary company based in Lakewood, N.J.



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