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 investment property.
Here’s what you need to know about 1031 Exchanges:
- Qualifying Property
- Minimum Purchase Price and Required Debt Replacement
- Timeline
- Qualified Intermediary
- Reporting to the IRS
- How to use a second or vacation home in a 1031 Exchange
- Investment Property or Personal Residence? Property Conversion
Qualifying Property
The replacement property must be like-kind: if you sell investment real estate, you will need to acquire investment real estate. Like-kind property is defined as any real property used for business or trade.
However, like-kind 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 used for investment purposes.
Qualifying properties cannot be:
- used as a primary residence*
- held primarily for sale
- vacation homes/second homes (see exception below)
- foreign property – all qualifying property must be located in the United States
Minimum Purchase Price and Debt Replacement
Minimum Replacement Purchase Price
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.
Replacement value isn’t the sales price of the first property. Luckily, the IRS allows you to deduct one-time closing costs:
Minimum Replacement Value = Sales Price minus non-recurring Closing Costs
Example: you sell your investment property for $850,000. The minimum replacement property price is $799,000:
Replacement Value = $850,000 – $51,000 non-recurring closing costs = $799,000
Non-recurring closing costs that can count here include such items as broker commissions, title and escrow fees, the qualified intermediary fee, transfer tax, and pro rated property tax.
To help you estimate your non-recurring closing costs, read my article about Seller Closing Costs.
Closing costs that do not qualify for tax deferment, so shouldn’t be included in the replacement value calculation, are items such as lender fees, any insurance premiums, repairs, home warranty premium, HOA dues, and any security deposits or rent pro rations.
Any cash left over from the exchange, and any debt relief, is called “boot,” and is immediately taxable.
Required Debt Replacement
In addition, you must re-acquire debt equal or greater to debt paid off from the relinquished property. For example, if you have $400,000 principal balance that you pay off when you sell the relinquished property, then you must take out a $400,000 loan for the replacement property. This can be a traditional loan, or seller financing.
If you choose not to replace the debt, then you will need to provide the $400,000 in new cash.
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, whichever comes first).
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.
Report the 1031 Exchange to the IRS
Be sure to inform the Internal Revenue Service of the 1031 Exchange. They require Form 8824, Like-Kind Exchanges, for the report. Attach Form 8824 to your income tax return.
Also – if you sell property in California and buy out of state, be sure to check the California Franchise Tax Board requirements, which may include Form 3840.
Use a Second or Vacation Home in a 1031 Exchange
Even though the 1031 Exchange is only for investment property, it’s possible to use a second or vacation home, if you follow the rules below. The IRS Revenue Procedure 2008-16 allows for this type of home to become eligible.
Here are the rules to follow:
- The property must be owned as an investment for two years prior to the Exchange if you are selling it, or after the Exchange if you are buying it.
- 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.
Always consult with a qualified tax advisor before you decide to convert any property from an investment to a personal residence.
Property Conversion
Investment to Primary Residence
You can convert an investment property to a primary residence simply by moving into it, and declaring it as your personal residence. Note that you need to live in the property for at least 3 years before you qualify for any capital gains exemption (IRS Section 121) if you sell it. Also, keep in mind that the exemption will be pro rated based on the historical use of the property – it won’t be 100%. Always consult with a qualified tax advisor before deciding to convert any property from an investment to a personal residence.
Primary Residence to Investment
You can convert a primary residence to an investment property by renting it out for two years. After two years of renting it out, if you 1031 Exchange the property within the following three years, you can still take the capital gains exemption (IRS Section 121) and deduct that from the replacement value minimum. Remember that you need to have occupied the property as your personal residence for two out of the last five years. Please consult with your tax advisor before deciding to covert a residence to an investment 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, or refuse to replace debt.
Estate planning is a common strategy with the 1031 Exchange. When done properly, 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 $15 million.
Capital gains tax rates are as high as 20% federal, and 13.3% California. Also, the tax rate for real estate 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.
