453 and 1031 Home Sales

Selling Property? Consider 453 & 1031 Home Sales

If you are a landowner or invest in real estate properties, you have probably heard of 1031 exchanges. But you may not have heard of IRC Section 453, which offers an alternative to 1031 exchanges, one that many landowners and investors may find favorable, dependent on their situation.

With Congress considering a change to IRC Section 1031, it’s probably beneficial to discuss alternatives with your tax attorney, especially since changes would most likely favor the IRS and not the landowner.

What is a 1031 Exchange?

In its most basic sense, a 1031 exchange is when a landowner sells a property and reinvests the proceeds in another property, thus deferring all capital gains taxes. Which is great, right? Because who likes taxes? But it’s not that simple; using a well-worn statement, some restrictions do apply. According to Real Wealth Network, here’s a breakdown of the rules:

  • The exchange must be between like-kind property.
  • Only investment or business property can be exchanged, no personal property.
  • The new property must be of equal or greater value than the property sold.
  • Same taxpayer / title holder needs to sell the existing property and purchase the new property.
  • The property owner must identify up to three replacement properties within 45 days of closing on the property being sold.
  • Replacement properties must be purchased within 180 days of closing of the original property. (There’s an exception if the property owner extends his tax return.)

So, 1031 exchanges enable you to defer capital gains taxes as well as facilitate significant portfolio growth and increased return on investment. However, the same article points out a potential risk of 1031 exchanges, especially for beginning investors, is the possibility of “the reduced basis for depreciation on the replacement property. This means that if you were to sell your replacement property, even at a deficit, you would still be accountable for the capital gains on the initial property. The takeaway here: Choose your replacement property wisely.

IRC Section 453

There are situations, however, in which a 1031 exchange may not make the best sense. Perhaps you are looking to retire or you are a second- or third-generation owner who wants out of the real estate market. If that is the case, you may not be looking to replace your property investment. Then, considering a sale transaction under IRC Section 453 may be just the solution.

In a 453 sale, instead of selling the property to a buyer, you “sell” the property to a facilitator or promoter who’s structuring the transaction, via a Note from the company purchasing the property or structuring the sale. That facilitator sells the property to the ultimate purchaser for cash and pays the seller the proceeds over the life of the Note. The seller claims installment sale treatment on her tax return and reports gain on a prorate basis, as principal payments are received. Therefore, you want to make sure you are dealing with a reputable facilitator. One article offers some of the potential perks of a 453 sale:

  • No 45-day or 180-day time limits
  • No like-kind limitation
  • No replacement requirement
  • No requirement to maintain current debt level
  • No carry-over basis applies
  • Can be exit strategy vs. forced reinvestment strategy

Another professional sings the praises of the IRC Section 453 because it helps to mitigate what he calls the “substantial risk” of buyer default; he identifies the benefits:

  • The owner sells the appreciated property without immediately paying capital gains taxes.
  • The seller receives payments over a set timeframe and pays capital gains taxes for same period.
  • The seller does not have to worry about buyer default because payments are guaranteed by a financial institution.

Looking Ahead

Since the future of 1031 exchanges may be uncertain, it’s good to have the 453 knowledge in your back pocket now as it just may end up helping your pocketbook in the long-term. What’s your best bet? Employing a tax attorney who can guide you to the best decision for your unique investment property situation.

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