How savvy investors use 1031s to defer capital gains and build wealth
In real estate, a 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred. The term—which gets its name from Internal Revenue Code (IRC) Section 1031—is bandied about by real estate agents, title companies, investors, and soccer moms. Some people even insist on making it into a verb, as in, “Let’s 1031 that building for another.”
IRC Section 1031 has many moving parts that real estate investors must understand before attempting its use. An exchange can only be made with like-kind properties, and Internal Revenue Service (IRS) rules limit use with vacation properties. There are also tax implications and time frames that may be problematic.
If you are considering a 1031—or are just curious—here is what you should know about the rules.
- A 1031 exchange is a swap of properties that are held for business or investment purposes.
- The properties being exchanged must be considered like-kind in the eyes of the Internal Revenue Service (IRS) for capital gains taxes to be deferred.
- If used correctly, there is no limit on how frequently you can do 1031 exchanges.
- The rules can apply to a former primary residence under very specific conditions.
What Is Section 1031?
Broadly stated, a 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. Most swaps are taxable as sales, although if yours meets the requirements of 1031, then 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 (as the IRS sees it) cashing out or recognizing a capital gain. That allows your investment to continue to grow tax deferred. There’s no limit on how frequently you can do a 1031. You can roll over the gain from one piece of investment real estate to another, and another, and another. Although you may have a profit on each swap, you avoid paying tax until you sell for cash many years later. Then, if it works out as planned, you’ll pay only one tax at a long-term capital gains rate (currently 15% or 20%, depending on income—and 0% for some lower-income taxpayers).
To qualify, most exchanges must merely be of like-kind—an enigmatic phrase that doesn’t mean what you think it means. 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. But there are traps for the unwary.
The 1031 provision is for investment and business property, although the rules can apply to a former primary residence under certain conditions. There are also ways that you can use 1031 for swapping vacation homes—more on that later—but this loophole is much narrower than it used to be.
To qualify for a 1031 exchange, both properties must be located in the United States.
Special Rules for Depreciable Property
Special rules apply when a depreciable property is exchanged. It can trigger a profit known as depreciation recapture, which 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, then the depreciation that 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.
Changes to 1031 Rules
Before passage of the Tax Cuts and Jobs Act (TCJA) in December 2017, some exchanges of personal property—such as franchise licenses, aircraft, and equipment—qualified for a 1031 exchange. Now, only real property (or real estate) as defined in Section 1031 qualifies. It’s worth noting, however, that the TCJA full expensing allowance for certain tangible personal property may help to make up for this change to tax law.
The TCJA includes a transition rule that permitted a 1031 exchange of qualified personal property in 2018 if the original property was sold or the replacement property was acquired by Dec. 31, 2017. The transition rule is specific to the taxpayer and did not permit a reverse 1031 exchange where the new property was purchased before the old property is sold.
Exchanges of corporate stock or partnership interests never did qualify—and still don’t—but interests as a tenant in common (TIC) in real estate still do.
1031 Exchange Timelines and Rules
Classically, an exchange involves a simple swap of one property for another between two people. But the odds of finding someone with the exact property that you want who wants the exact property that you have are slim. For that reason, the majority of exchanges are delayed, three-party, or Starker exchanges (named for the first tax case that allowed them).
In a delayed exchange, you need a qualified intermediary (middleman), who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. This three-party exchange is treated as a swap.
There are two key timing rules that you must observe in a delayed exchange.
The first relates to the designation of a replacement property. Once the sale of your 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 that you want to acquire.
The IRS says you can designate three properties as long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.
The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old property.
The two time periods run concurrently, which means that you start counting when the sale of your property closes. For example, if you designate a replacement property exactly 45 days later, you’ll have just 135 days left to close on it.
It’s also possible to buy the replacement property before selling the old one and still qualify for a 1031 exchange. In this case, the same 45- and 180-day time windows apply.
To qualify, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and then complete the transaction within 180 days after the replacement property was bought.
1031 Exchange Tax Implications: Cash and Debt
You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as boot—will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
One of the main ways that people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property that you relinquish, as well as any debt on the replacement property. If you don’t receive cash back but your liability goes down, then that also will be treated as income to you, just like cash.
Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property that you receive in exchange is only $900,000. In that case, you have a $100,000 gain that is also classified as the boot and will be taxed.
1031s for Vacation Homes
You might have heard tales of taxpayers who used the 1031 provision to swap one vacation home for another, perhaps even for a house where they want to retire, and Section 1031 delayed any recognition of gain. Later, they moved into the new property, made it their primary residence, and eventually planned to use the $500,000 capital gain exclusion. This allows you to sell your primary residence and, combined with your spouse, shield $500,000 in capital gain, as long as you’ve lived there for two years out of the past five.
In 2004, Congress tightened that loophole. However, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Example: You stop using your beach house, rent it out for six months or a year, and then exchange it for another property. If you get a tenant and conduct yourself in a businesslike way, then you’ve probably converted the house to an investment property, which should make your 1031 exchange all right.
Per the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.
Moving Into a 1031 Swap Residence
If you want to use the property for which you swapped as your new second or even primary home, you can’t move in right away. In 2008, the IRS set forth a safe harbor rule, under which it said it would not challenge whether a replacement dwelling qualified as an investment property for purposes of Section 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange:
- You must rent the dwelling unit to another person for a fair rental for 14 days or more.
- Your 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 that the dwelling unit is rented at a fair rental.
Moreover, after successfully swapping one vacation or investment property for another, you can’t immediately convert the new property to your primary home and take advantage of the $500,000 exclusion.
Before the law was changed in 2004, an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence.
Now, if you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date when the property was acquired in the 1031 like-kind exchange. In other words, you’ll have to wait a lot longer to use the primary residence capital gains tax break.
1031s for Estate Planning
One of the downsides of 1031 exchanges is that the tax deferral will eventually end and you’ll be hit with a big bill. However, there is a way around this.
Tax liabilities end with death, so if you die without selling the property obtained through a 1031 exchange, then your heirs won’t be expected to pay the tax that you postponed paying. They’ll inherit the property at its stepped-up market-rate value, too.
These rules mean that a 1031 exchange can be great for estate planning.
How to Report 1031 Exchanges to the IRS
You must notify the IRS of the 1031 exchange by compiling and submitting Form 8824 with your tax return in the year when the exchange occurred.
In the form, you’ll be asked to provide descriptions of the properties exchanged, the dates when they were identified and transferred, any relationship that you may have with the other parties with whom you exchanged properties, and the value of the like-kind properties. You’re also required to disclose the adjusted basis of the property given up and any liabilities that you assumed or got rid of.
It’s important to complete the form correctly and without error. If the IRS believes that you haven’t played by the rules, then you could be hit with a big tax bill and penalties.
Can You Do a 1031 Exchange on a Primary Residence?
Usually, a primary residence does not qualify for 1031 treatment because you live in that home and do not hold it for investment purposes. However, if you rented it out for a reasonable time period and refrained from living there, then the primary residence becomes an investment property, which might make it eligible.
Can You Do a 1031 Exchange on a Second Home?
1031 exchanges apply to real property held for investment purposes. Therefore, a regular vacation home won’t qualify for 1031 treatment unless it is rented out and generates an income.
How Do I Change Ownership of Replacement Property After a 1031 Exchange?
If that is your intention, then it would be wise not to act straightaway. It’s generally advisable to hold onto the replacement property for several years before changing ownership. If you get rid of it quickly, the Internal Revenue Service (IRS) may assume that you didn’t acquire it with the intention of holding it for investment purposes—the fundamental rule for 1031 exchanges.
What is an Example of a 1031 Exchange?
Kim owns an apartment building that’s currently worth $2 million, double what she paid for it seven years ago. She’s content until her real estate broker tells her about a larger condominium located in an area fetching higher rents that’s on the market for $2.5 million.
By using the 1031 exchange, Kim could, in theory, sell her apartment building and use the proceeds to help pay for the bigger replacement property without having to worry about the tax liability straightaway. She is effectively left with extra money to invest in the new property by deferring capital gains and depreciation recapture taxes.
What is 1031 Exchange Depreciation Recapture?
Depreciation enables real estate investors to pay lower taxes by deducting the costs of wear and tear of a property over its useful life.
Normally, when that property is eventually sold, the IRS will want to recapture some of those deductions and factor them into the total taxable income. A 1031 can help to delay that event by essentially rolling over the cost basis from the old property to the new one that is replacing it. In other words, your depreciation calculations continue as if you still own the old property.
The Bottom Line
A 1031 exchange can be used by savvy real estate investors as a tax-deferred strategy to build wealth. However, the many complex moving parts not only require understanding the rules but also enlisting professional help—even for seasoned investors.
Courtesy of Investopedia.com