The 1031 Exchange is slowly making its way into daily conversation by Realtors, title companies, and investors. Please keep in mind that Section 1031 isn’t restricted to Real Estate but this is where most of the discussion takes place.
Although most sales are taxable as sales, if you use 1031, you’ll either have no tax or limited tax due at the time of the exchange.
In effect, you can change the form of your investment without cashing out or recognizing a capital gain. There’s no limit on how many times or how frequently you can do a 1031 exchange. Although you may have a profit on each swap, you can avoid tax until you actually sell for cash many years later.
In general, if you swap one building for another building, you can avoid depreciation 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 exchange. If you’re considering a 1031 exchange, or just curious, here are 10 things you should know.
1. A 1031 isn’t for personal use.
The provision is only for investment and business property, so you can’t swap your primary residence for another home. There are ways you can use a 1031 for swapping vacation homes.
2. Some personal property qualifies.
Most 1031 exchanges are of real estate. However some exchanges of personal property (say – a valuable painting) can qualify.
3. “Like-kind” is broad.
Most exchanges must merely be of “like-kind.” You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another.
4. You can do a “delayed” exchange.
An exchange involves a simple swap of one property for another between two people;e. But the odds of finding someone with the exact property you want who wants the exact property you have are slim. For that reason the vast majority of exchanges are delayed. in a delayed exchange, you need a middleman who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. That middleman is called the “intermediary.”
5. You must designate replacement property.
Once the sale of 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 you want to acquire.
6. You can designate multiple replacement properties.
The IRS says you can designate three properties as the designated replacement property so long as you eventually close on one of them.
7. You must close within 6 months.
You must close on the property within 180 days of the sale of the old property. YOu start counting when the sale of your property closes. If you designate a replacement property 45 days later, you’ll have 135 days left to close on the replacement property.
8. If you receive cash, it’s taxed.
You may have cash left over the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of hte 180 days. That cash – known as “boot” – will be taxed as partial sales proceeds from the sale of your property, generally as capital gain.
9. You must consider mortgages and other debt.
One of the main ways people get into trouble with these transactions is failing to consider loans. Suppose you had a mortgage of $1-million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. You have $100,000 of gain that is also classified as “boot,” and it will be taxed.
10. Using a 1031 for a vacation house requires caution.
You can sell your primary residence and, combined with your spouse, shield $500,000 in capital gain, so long as you’ve lived in your home for two years out of the past five. But this break isn’t available for your second or vacation home. Yes, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Example: You stop using the beach house, rent it out for six months or a year and then exchange it for other real estate. If you actually get a tenant you’ve probably converted the house investment property, which should make the 1031 exchange OK.
In 2008 the IRS set forth a safe harbor rule.
To meet safe harbor, in each of the two 12 month periods immediately after the exchange: (1) you must rent the dwelling unit to another person for a fair rental rate for 14 days or more; and (2) 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.
Glossary:
Relinquished property: The original property being sold by the taxpayer when making an exchange.
Replacement property: The new property being acquired by the taxpayer when making an exchange.
Qualified intermediary: Accommodator, facilitator, qualified escrow holder. A third party that helps to facilitate the exchange.