What is a 1031 Tax Deferred Exchange?

A 1031 tax-deferred exchange provides a great way for investors to defer capital gains taxes by selling one investment property and using those same funds to purchase a different investment property. The 1031 tax-deferred exchange receives its name from the IRS tax code Section 1031, which lays out the rules for these types of like-kind exchanges. If you are considering a like-kind exchange, our firm can help you understand the tax implications and requirements. Are you considering a like-kind exchange? Just intrigued? Here are some things you should consider.

Section 1031 Defined

Briefly defined, a 1031 exchange occurs when an investor sells one investment property and purchases a different one. Typically, when you sell an investment property, cashing out, the IRS recognizes the profit as a capital gain. When you 1031 exchange or like-kind exchange a property, it allows your investments to grow tax-deferred.

There are no limits to the number of times you can roll over the gain, continuing to kick the capital gains can down the road. The capital gains tax will not be due until you cash out, which can be many years later. Then with careful planning, you will only pay one tax: a long-term capital gains tax. This provides a great way for investors to build wealth.

What Properties Qualify for a Like-Kind Exchange?

A like-kind exchange does not mean you need to sell and purchase similar properties. You can exchange a single-family home for an apartment building or a farm for vacant land. The properties do not have to be exactly the same. However, it must be an exchange of one business property for another. However, there are specific circumstances outlined below where you can exchange one vacation home for another investment property.

Depreciable Property

Do not exchange depreciable property for non-depreciable property without understanding the tax implications. When taxpayers depreciate a property on their tax returns and then sell the property, they are required to do what the IRS calls recapture the depreciation. This means that the amount depreciated over the years is recalculated and taxed at the taxpayer’s ordinary income tax rate. The IRS requires most buildings, even single-family rental properties, be depreciated. This means whether you took the depreciation or not, the IRS will require you to recapture and pay ordinary income tax on the depreciation you should have taken.

When making a like-kind exchange, you can avoid this depreciation recapture by swapping one building for another or improved land for improved land. However, if your like-kind exchange involves selling improved land and purchasing unimproved, vacant land, then the depreciation on the property you sold would be recaptured, and the ordinary income tax owed on that amount would be due. Completing the like-kind exchange on this type of property swap can still prove beneficial, helping you kick the capital gains tax can down the road, but you will not be able to avoid the ordinary income tax on the amount of the depreciation recaptured.

Timing Requirements

Finding someone who has the exact property you want and who also wants to exchange properties with you is rare. Most like-kind exchanges are delayed exchanges, involving selling your current property and purchasing a new property in separate transactions. In order not to allow people to sell their current properties and just hold onto the cash without paying capital gains tax for an extended period of time, the IRS imposes two main timing rules you must meet to qualify for the like-kind exchange, in addition to needing a qualified middle person (intermediary) to hold onto the cash from the sale of your current property until you use it to buy your new property.

45-Day Rule. Once you sell your current property, the intermediary will receive the cash from the sale. Then the clock starts ticking. You have 45 days from the sale of your property to specify in writing to your intermediary stipulating your replacement property that you plan to acquire. The IRS will allow you to designate three properties, and if you fall within certain valuation tests, you may be able to designate more than three properties. You only need to close on one of them, which brings you to the next timing rule.

180-Day Rule. This timing rule relates to the closing on the property you are purchasing to replace your investment property you sold. You must close on your new Section 1031 property within 180 days from the date your other property sold.

Example. Bob and Anne sold their apartment building on June 1. The cash from the sale of the property was held by their intermediary. On June 30, they notified their intermediary of three properties they were considering purchasing.

Because Bob and Anne chose an intermediary to hold their funds from the sale of their property and notified the intermediary of three properties they are considering purchasing within 45 days, they met the first timing requirement of the IRS, required to qualify for a like-kind exchange. To meet the second IRS timing requirement, they will need to close by November 27 -- 180 days from the date of the sale. Both IRS timing requirements run concurrently. This means Bob and Anne only have 150 days (180 days - 30 days) to close from the date they notified their intermediary of the three properties they were considering on June 30.

Vacation Homes - Section 1031

With some careful planning, you can complete a like-kind exchange on your vacation home. It requires you to conduct yourself in a businesslike way and switch your vacation home to an investment property for six to twelve months before you sell it. The easiest way for most people to switch a vacation home to an investment property is to change it to a rental property. It does require you to rent out the property. Just holding the property out for rent and never having tenants will not be enough. The IRS looks at the facts and timing. The longer the property is held as an investment property the better. However, there is no absolute standard. Anything less than six months as a bona fide rental is probably not enough.

Safe Harbor Rule. If you want to use your new property as your primary or vacation home, you will not be able to use it immediately and qualify for a like-kind exchange. To qualify under the Safe Harbor Rule established by the IRS, the property you purchased must qualify as an investment property. This means for each of the two 12-months immediately following the exchange, the property must be rented for a fair rental price for 14 days or more; and your personal use of the property cannot exceed either the greater of 14 days or 10% of the number of days during the 12-month period that the property is rented at a fair rental price.

If the property qualifies for the Section 1031 tax-deferred exchange, you start using the property as your personal residence, and hold the property for a five-year period, it can qualify for the primary residence capital gains break. Currently, this tax break is $500,000 for married couples filing jointly. Applied correctly, this provides a substantial tax break and can save you thousands in capital gains tax.

1031 Tax Deferred Exchange Recap

Section 1031 like-kind exchanges provide a great way for investors to build wealth by using tax-deferred strategies. Pulling off a like-kind exchange requires several moving parts. You need to sell one investment property and purchase another one. Also, you have to use an intermediary to hold the funds between the sale and purchase of the properties in addition to meeting the two timing rules. If you are considering a Section 1031 tax-deferred exchange, it is important to make sure you understand all the steps involved, so the sale and purchase of your properties qualify. To make sure you do not get hit with an unexpected tax bill, visit our office, or schedule an appointment today with the accounting and tax preparation professionals at Gudorf Tax Group.