Do you want to sell investment property, and then defer capital gains tax through a 1031 Exchange?
Thanks to Internal Revenue Code Section 1031, you are allowed to postpone capital gains taxes, if you reinvest the proceeds in a similar property.
Here’s what you need to know about 1031 Exchanges:
- Qualifying Property
- Sale Prices
- Timeline
- Qualified Intermediary
- How to use a personal residence in a 1031 Exchange
Qualifying Property
The replacement property must be like-kind: if you sell investment real estate, you will need to acquire investment real estate. However, the properties don’t need to be similar use. For example, you can exchange a parking lot for an apartment building, or a collection of condos for a retail strip mall.
Both the relinquished and replacement properties must be held for investment purposes – it can’t be property that you use personally. You cannot occupy a qualifying property, such as a vacation rental, for more than 14 days per year.
Qualifying properties cannot be:
- used as a primary residence
- held primarily for sale
- vacation homes/second homes
- foreign property – all qualifying property must be located in the United States
Sale Prices
For a fully-deferred exchange, you must buy replacement property of greater or equal value, and reinvest all proceeds from the sale of the relinquished properties. In addition, you must re-acquire debt equal or greater to debt paid off from the relinquished property, or replace the debt with additional cash.
Any cash left over from the exchange, and any debt relief, is immediately taxable.
1031 Exchange Timeline
The timeline to purchase replacement property begins on the day that you close escrow on the relinquished property. This is Day 0. There are two deadlines: Day 45 and Day 180 (or tax return due date).
Day 45 – Identify Replacement Properties
You have 45 days to identify replacement property. You cannot decide to purchase a different property after Day 45. Property descriptions need to be made in writing, signed, and sent to your qualified intermediary no later than Day 45.
This 45 day timeline can be extended due to:
- Military deployment, or
- A federally declared disaster.
The two most common identification rules are:
- 3-Property Rule – You can identify any three properties. You are not required to purchase all three.
- 200% Rule – You can identify properties whose combined fair market value does not exceed 200% of the relinquished property. For example, if you just sold a property for $250,000, you can identify a group of properties with a combined value of no more than $500,000.
Day 180 (or tax return due date) – Complete the Exchange
You must acquire the replacement properties no later than 180 days after the transfer of relinquished properties. If your tax return due date comes before that, then the deadline is your tax return due date. Many investors participating in a 1031 Exchange will file extensions to keep the deadline at 180 days.
Qualified Intermediary
You must use a qualified intermediary for the entire exchange. The qualified intermediary will acquire and sell the relinquished property, and hold funds from the sale of the relinquished property.
This means that you need to hire a qualified intermediary BEFORE you close escrow on the original property. If you sell your original property without a qualified intermediary, you will receive the net proceeds directly. If you receive any proceeds before the exchange is complete, you may disqualify the entire transaction from a 1031 Exchange.
A qualified intermediary will prepare the exchange documents, and coordinate wire fund transfers. The flat fee is usually between $1,000 and $2,000, depending on the number of properties and their values. This is often paid from the proceeds of the exchange.
Keep in mind that there are no licensing requirements for qualified intermediaries. Be sure to choose a company that is reputable and bonded.
Use a Personal Residence in a 1031 Exchange
Even though the 1031 Exchange is only for investment property, there is a way to use it to buy or sell a personal home. The IRS Revenue Procedure 2008-16 allows for a vacation home to become eligible.
Here are the rules to follow:
- The property must be owned for two years prior to the Exchange.
- During these two years, you must rent out the property for at least 14 days per year. In addition, you must charge a fair market value for rent.
- You can use the property for personal purposes. However, the time you’re allowed to use it is limited. You can use the property for the greater of: 14 days per year, or 10% of the time you rent it out. For example, if you rent out the property for 200 days per year, you can use it for maximum 20 days per year.
If you follow these rules, you can sell a second or vacation home.
You can also buy a home through a 1031 Exchange. First, you need to rent it out for at least 14 days per year for the first two years. You also can’t personally use it for more than 14 days per year. Once you do that, you can convert it to your personal residence. Of course, you should consult with a qualified tax advisor before you decide to convert any property.
The Bottom Line
The 1031 Tax Deferred Exchange can help investors acquire more valuable investment properties. An investor may exchange one property for several others, consolidate multiple properties into one, and acquire property anywhere in the United States. Taxes aren’t due unless you cash out on the equity.
Estate planning is a common strategy with the 1031 Exchange. Whoever inherits the property can then sell it without paying taxes. The only exception is if you exceed the estate tax threshold, which is currently about $5.5 million.
Capital gains tax rates are as high as 20% federal, and 13.3% California. Also, the tax rate for depreciation recapture is 25%. Finally, there is often a healthcare surtax, which is about 3.8% of the gain. Deferring these taxes will increase your immediate purchasing power.
Here’s the IRS Fact Sheet for Like-Kind Exchanges.
As always, contact me with any questions.
