A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred.
IRC Section 1031 has many moving parts that real estate investors must understand before attempting its use. An exchange can only be made with like-kind properties, and Internal Revenue Service (IRS) rules limit its use with vacation properties. There are also tax implications and time frames that may be problematic.
If you are considering a 1031 exchange—or are just curious—here is what you should know about the rules.
Classically, an exchange involves a simple swap of one property for another between two people. However, the odds of finding someone with the exact property that you want who wants the exact property that you have are slim. For that reason, the majority of exchanges are delayed, three-party, or Starker exchanges (named for the first tax case that allowed them).
In a delayed exchange, you need a qualified intermediary (middleman), who holds the cash after you sell your property and uses it to buy the replacement property for you. This three-party exchange is treated as a swap.
There are two key timing rules that you must observe in a delayed exchange.
The first relates to the designation of a replacement property. Once the sale of your property occurs, the intermediary will receive the cash. 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 the replacement property in writing to the intermediary, specifying the property that you want to acquire.
The IRS says you can designate three properties as long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.
The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old property.
The two time periods run concurrently, which means that you start counting when the sale of your property closes. For example, if you designate a replacement property exactly 45 days later, you’ll have just 135 days left to close on it.
It’s also possible to buy the replacement property before selling the old one and still qualify for a 1031 exchange. In this case, the same 45- and 180-day time windows apply.
To qualify, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and then complete the transaction within 180 days after the replacement property was bought.
You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as boot—will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
One of the main ways that people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property that you relinquish, as well as any debt on the replacement property. If you don’t receive cash back but your liability goes down, then that also will be treated as income to you, just like cash.
Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property that you receive in exchange is only $900,000. In that case, you have a $100,000 gain that is also classified as the boot and will be taxed.
You might have heard tales of taxpayers who used the 1031 provision to swap one vacation home for another, perhaps even for a house where they want to retire, and Section 1031 delayed any recognition of gain. Later, they moved into the new property, made it their principal residence, and eventually planned to use the $500,000 capital gain exclusion. This allows you to sell your principal residence and, combined with your spouse, shield $500,000 in capital gain, as long as you’ve lived there for two years out of the past five.
In 2004, Congress tightened that loophole.10 However, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. For example, you stop using your beach house, rent it out for six months or a year, and then exchange it for another property. If you get a tenant and conduct yourself in a businesslike way, then you’ve probably converted the house to an investment property, which should make your 1031 exchange all right.
Per the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.
If you want to use the property for which you swapped as your new second or even principal home, you can’t move in right away. In 2008, the IRS set forth a safe harbor rule, under which it said it would not challenge whether a replacement dwelling qualified as an investment property for purposes of Section 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange:
Moreover, after successfully swapping one vacation or investment property for another, you can’t immediately convert the new property to your principal home and take advantage of the $500,000 exclusion.
Before the law was changed in 2004, an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence.
Now, if you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date when the property was acquired in the 1031 like-kind exchange. In other words, you’ll have to wait a lot longer to use the principal residence capital gains tax break.
One of the downsides of 1031 exchanges is that the tax deferral will eventually end and you’ll be hit with a big bill. However, there is a way around this.
Tax liabilities end with death, so if you die without selling the property obtained through a 1031 exchange, then your heirs won’t be expected to pay the tax that you postponed paying. They’ll inherit the property at its stepped-up market-rate value, too.14 These rules mean that a 1031 exchange can be great for estate planning.
You must notify the IRS of the 1031 exchange by compiling and submitting Form 8824 with your tax return in the year when the exchange occurred.
The form will require you to provide descriptions of the properties exchanged, the dates when they were identified and transferred, any relationship that you may have with the other parties with whom you exchanged properties, and the value of the like-kind properties. You’re also required to disclose the adjusted basis of the property given up and any liabilities that you assumed or relinquished.
It’s important to complete the form correctly and without error. If the IRS believes that you haven’t played by the rules, then you could be hit with a big tax bill and penalties.
A principal residence usually does not qualify for 1031 treatment because you live in that home and do not hold it for investment purposes. However, if you rented it out for a reasonable time period and refrained from living there, then it becomes an investment property, which might make it eligible.
1031 exchanges apply to real property held for investment purposes. Therefore, a regular vacation home won’t qualify for 1031 treatment unless it is rented out and generates an income.
If that is your intention, it would be wise not to act straightaway. It’s generally advisable to hold onto the replacement property for several years before changing ownership. If you get rid of it quickly, the IRS may assume that you didn’t acquire it with the intention of holding it for investment purposes—the fundamental rule for 1031 exchanges.
Kim owns an apartment building that’s currently worth $2 million, double what she paid for it seven years ago. She’s content until her real estate broker tells her about a larger condominium located in an area fetching higher rents that’s on the market for $2.5 million.
By using the 1031 exchange, Kim could, in theory, sell her apartment building and use the proceeds to help pay for the bigger replacement property without having to worry about the tax liability straightaway. She is effectively left with extra money to invest in the new property by deferring capital gains and depreciation recapture taxes.
Depreciation enables real estate investors to pay lower taxes by deducting the costs of wear and tear of a property over its useful life.
Normally, when that property is eventually sold, the IRS will want to recapture some of those deductions and factor them into the total taxable income. A 1031 exchange can help to delay that event by essentially rolling over the cost basis from the old property to the new one that is replacing it. In other words, your depreciation calculations continue as if you still owned the old property.
A 1031 exchange can be used by savvy real estate investors as a tax-deferred strategy to build wealth. However, the many complex moving parts not only require understanding the rules, but also enlisting professional help—even for seasoned investors.
This data is provided for information purposes only and should not be substitution for legal advice. Please consult a tax advisor or legal counsel.
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