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What is IRS Section 1031?
A 1031 exchange, on its most basic level, is a swap or exchange of one investment property for another property. Although most investment property swaps will be considered taxable events, if your swap meets the requirements of IRS Section 1031, you’ll be able to either limit your taxable liability, or have no taxes owed at all. Section 1031 exchanges are also known as a “like-kind” exchange or a “Starker”.
As the IRS sees it, you can basically change the form of your investment property without actually cashing out or recognizing a capital gain for tax purposes. That allows your investment, similar to an IRA, to continue to grow tax-deferred until you ultimately sell the property and keep the cash. The best part is that there is no limit on how many times you can do a 1031 exchange. There is also not a frequency cap in place for 1031 exchanges. This allows you to roll over gains on a current real estate investment property to another investment property without having to pay any taxes on those gains. When you ultimately decide to sell your investment property without doing a 1031 exchange for another property, you’ll hopefully only pay long-term capital gains tax that one time.
One fact to note is that 1031 exchanges cannot be swapped for your primary residence. The provision only works for business property and investment property. As for vacation homes, there is a way to successfully leverage a 1031 exchange, but this loophole is getting much more difficult to use than in the past as we explain in greater detail below.
Rules for Depreciable Property
There is a special rule when a depreciable investment property is exchanged via section 1031. Here’s how it works. If you exchange land that has been improved with a building for unimproved land without a building, the depreciation you’ve previously claimed on the building will be recaptured as ordinary income. This is profit type is considered “depreciation recapture”. If you simply swap one building for another building you can avoid this depreciation recapture profit entirely. We always recommend working with professional help with conducting a 1031 exchange and it’s extremely important to have accurate Real Estate Accounting for your properties.
“Like-Kind” is Very Broad
Most 1031 exchanges must be of “like-kind” – an ambiguous phrase that doesn’t necessarily mean what you think it means. You can exchange a strip mall for an apartment building, or a ranch for a raw plot of land. The “Like-Kind” rules are extremely liberal and left for interpretation. You can even exchange one business for another. But again, there are traps and we do always recommend working with a professional to understand all variables with an exchange.
‘Delayed’ 1031 Exchange
In the past, a 1031 always involved a swap of one investment property for another between two separate parties. As you can imagine, the odds of finding another party who wants the exact property you have is very slim. Because of this, you will find that a majority of 1031 exchanges are delayed, three-party, or “Starker” exchanges.
In a delayed 1031 exchange, you need to use a Qualified Intermediary who will hold the cash after you “sell” your property. This Qualified Intermediary then uses the cash to “buy” the replacement property for you. This is a three-party exchange and is treated as a swap.
Timeframe Regulations for 1031 Delayed Exchange
When doing a 1031 delayed exchange, please note there are two essential timing rules you must observe.
- The first timing rule revolves around the handling of cash upon closing and the designation of the property. Once the sale of your property is finalized, the third-party intermediary we mentioned earlier will receive the cash. THIS IS KEY. You can’t receive the cash, or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate up to three replacement properties in writing to the intermediary, specifying the property you wish to acquire. The IRS says you can designate three properties so long as you eventually close on one of them.
- The second timing rule in a delayed exchange states that you must close on the new property within 180 days of the sale of the old. So, for example, if you designate replacement property exactly 35 days after the sale, you’ll have just 145 days left to close on the new replacement property.
1031s Mortgage and Tax Implications
When determining if you owe taxes, one of the biggest mistakes people make is failing to consider the loans they have on the property. You MUST consider the debt and/or mortgage loans on the property you sell, and any debt on the replacement property you purchase. So, if your liability goes down, even if you don’t receive cash, it will be treated like income just like cash. For example, suppose you had $500k mortgage on the old property and your mortgage on the new property is only $400k, you will have to pay tax on that $100k. That $100k, also called “Boot”, will likely be taxed at capital gains.
If you have cash left over after the third-party intermediary acquires the replacement property on your behalf, you will be taxed as partial sales proceeds from the sale of your property.
1031 Exchange For Vacation Homes
In 2004, Congress tightened the loophole on 1031 exchanges for vacation homes. To ensure your vacation home qualifies for a 1031 exchange, you must actively rent the home out for 6-12+ months prior to conducting an exchange. It’s preferred that the vacation home be rented for over twelve months. However, if you merely attempt to rent the home out but never actually have a tenant, it likely won’t quality for a 1031 exchange.
Making 1031 Swap Primary or Secondary Residence
If you want to use the property you swapped for as your new second or even primary home, you must abide by the safe harbor rule the IRS set forth in 2008. Under the safe harbor rule, the IRS said it would not challenge whether a replacement dwelling qualifies as an investment property for purposes of Section 1031. In order to meet that safe harbor, in each of the two 12-month periods immediately after the exchange:
- You must rent the dwelling unit to another person for a fair rental for 14 days or more
- Your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
If you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence (to try and take advantage of the $500,000 exclusion), the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange.
1031 Rule Changes
Prior to the passage of the new tax legislation Dec. 22, 2017, some exchanges of personal property – such as equipment, aircraft, and franchise licenses – were able to quality for a 1031 exchange. Under the new tax law, only investment or business real estate qualifies.
Source: Oakley Reality