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A 1031 construction exchangeenables the taxpayer to defer federal and state capital gains and recapture depreciation taxes on the sale of existing property, and construct improvements to a replacement property.In what is known as a 1031 tax deferred exchange, a construction exchange of equal or greater value to the old or relinquished property is quite common.
Long known as a viable tax deferral strategy, the Internal Revenue Code (IRC) §1.1031 states no gain or loss is recognized when property held for trade, business or investment is exchanged for like-kind property held for trade, business or investment. No gain is recognized means the tax obligation is postponed, delayed or deferred until the replacement property is sold. Real property can be exchanged for any real property given the duration of interest, being recognized as real property by the state and if located in the United States, the real property is exchanged for property held in the United States. International real property is eligible for 1031 exchanges when exchanged for any real property located overseas.
Given the timeframe to complete the construction exchange is 180 calendar days starting the day after the closing on the replacement or relinquished property, planning is critical. Weather can delay construction and the only 1031 eligible extensions include Presidentially declared disasters such as floods, tornadoes and hurricanes, or if the taxpayer is in a declared combat zone. Examples of a construction exchange include:
Land or real property already owned can also be improved in a leasehold improvement exchange. The property to be improved must be owned by a related party at least six months prior to the start of the exchange. In addition, the improved property must be leased for at least two years following the end of the exchange by the related party (landlord) and the taxpayer at fair market rent.
If the relinquished property sold for $500,000, then a possible 1031 exchange could be the purchase of land for $150,000 and improvements of $350,000 or more. For the improvements to be eligible for the tax deferral, the materials and services must be affixed to the property by the 180th calendar day. If not, the percentage complete is determined and will represent the gain deferred.
Another option is a non-safe harbor construction exchange where the completion date can be beyond the 180th calendar day.
Related articles of interest include:
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