Section 1031 Basics
A 1031 exchange is an exchange of one investment property for another. Although most swaps are taxable as sales, no limited taxes or duties will apply at the time of the exchange if your swaps meet 1031 requirements. In fact, you can change the form of your investment without (as the IRS sees it) paying or recording any capital gains. This means that your investment can continue to grow deferred for tax purposes.
There is no limit to the frequency or number of times you can make a 1031 exchange. You can transfer the profit from one investment property to another, to another and to another. Although you can make a profit on any swap, you avoid taxes until you sell for cash. So if it works as expected, you will only pay a tax with a long-term capital gain rate (currently 15% or 20% depending on income and 0% for some low-income taxpayers).
Most exchanges just have to be “like-for-like” – a bewildering phrase that doesn’t mean what you think it means. You can trade a house for a farm for a shopping mall. The rules are surprisingly liberal. You can even exchange one company for another. But there are traps for the unwary. Provision 1031 applies to investment and commercial real estate, although the rules may apply to a former primary residence under certain conditions.
Depreciable Property Rules
Special rules apply when a depreciable property is exchanged. It can trigger a profit known as depreciation recapture that is taxed as ordinary income. In general, if you swap one building for another building you can avoid this recapture. But if you exchange improved land with a building for unimproved land without a building, the depreciation you’ve previously claimed on the building will be recaptured as ordinary income.
Such complications are why you need professional help when you’re doing a 1031.
When exchanging a depreciable property, special rules apply. This can trigger a profit called depreciation recapture, which is taxed as ordinary income. In general, swapping a building for another building can avoid this recovery. However, if you exchange an improved land for a building with an unimproved land without buildings, the previously claimed depreciation on the building will be returned as ordinary income.
Such complications are why you need professional help when running a 1031.
Typically, an exchange involves a simple exchange of one property for another between two people. But the chances of finding someone with exactly the stretch you want, who wants the exact property you have are slim. For this reason, most exchanges are delayed exchanges, three-party exchanges, or Starker exchanges (named after the first tax case that made this possible).
In the event of a late exchange, you will need a qualified broker to hold the money after you “sell” your property and then “buy” the replacement property for you. This three-way trade is treated as a trade.
There are two important timing rules to keep in mind when making a delayed trade:
The first refers to the name of a replacement property. As soon as your property is sold, the agent receives the money. You cannot get the money or it will affect treatment 1031. Also, within 45 days of selling your property, you must designate the replacement property in writing to the broker stating the property you wish to purchase.10 According to the IRS, you can designate three properties as long as none close one. You can also specify more than three if they fit into certain assessment tests.
The second timing rule in a delayed trade is related to closing. You must close the new property within 180 days of selling the old one. The two periods expire at the same time, which means you start counting when the sale of your property is complete. For example, if you designate a replacement property exactly 45 days later, you only have 135 days to close it.
After the broker purchases the replacement item, there may be some money left. In this case, the agent pays you at the end of the 180 days. This money – known as a “boot” – is taxed as partial sales proceeds from the sale of your property, usually as capital gains.
One of the main ways people get into trouble with these transactions is to ignore credit. You will need to consider any mortgage loans or other debts for the property you are giving up, as well as any debts for the replacement home. If you do not receive your refund but your liability is reduced, it will be treated as income, just like cash.
For example, let’s say you have a $ 1 million mortgage on the old property, but your new mortgage on the property in return is only $ 900,000. You have a profit of $ 100,000 which is taxed.
1031s for Vacation Homes
You may have heard stories of taxpayers using provision 1031 to swap one vacation home for another, perhaps even for a retirement home, and Section 1031 delayed recognition of profits. They later moved into the new property, making it their primary residence, and eventually planned to take advantage of the $ 500,000 capital gains exclusion. This allows you to sell your primary residence and, together with your spouse, protect a $500,000 capital gain as long as you have lived there for two years in the past five years.
In 2004, Congress closed that loophole. Taxpayers can still convert vacation homes into rental properties and conduct 1031 exchanges. Example: You stop using your beach house, rent it for six months or a year and then exchange it for another property. If you take a tenant and do business, you’ve probably converted the house into an investment property, which should make your 1031 fine.
However, if you only offer it for rent but never have renters, it’s probably not allowed. The facts will be crucial, as will the timing. The more time passes after converting the use of the property into a rental, the better. While there is no absolute standard, a good rental of less than six months is probably not enough. A year would be better.
Moving into a 1031 Property
If you wish to use the property you have exchanged as a new second home or even as a main home, you cannot move in right away. In 2008, the IRS established a safe harbor rule that would not question whether a replacement home qualifies as an investment property for the purposes of Section 1031.14 In order to meet the safe harbor in one of the two 12-month periods following the exchange:
- You must rent the unit to someone else for a fair rent for 14 days or more
- Personal use of the accommodation unit must not exceed 14 days or 10% of the number of days during the 12 month period that the accommodation unit is rented at a reasonable price.
Also, after you have successfully exchanged a vacation or real estate investment, you cannot immediately convert the new property into the primary residence and take advantage of the $ 500,000 foreclosure.
Before the law was changed in 2004, an investor could transfer a rental property on a 1031 stock exchange to another rental property, rent the new rental property for a period of time, move into the property for a few years, and then sell it. using the exclusion of profit from the sale of a primary residence. Now, if you purchase a property on a 1031 trade-in and subsequently attempt to sell that property as your primary residence, the exclusion will not apply for the five-year period from the date the property was acquired on the 1031 trade-in. In other words, we will have to wait a long time to take advantage of the tax deduction on capital gains for primary residence.
A 1031 exchange can be used by experienced real estate investors as a deferred wealth creation strategy. The numerous and complex moving parts require not only an understanding of the rules, but also professional help, even for experienced investors.