1031 Exchange in Real Estate
The new (2018) tax law made some big changes to Section 1031, but that’s not bad news for real estate investors. Section 1031 now only applies to real estate. (It no longer applies to exchanges of personal or intangible property.)
If you own an investment or business property, you will almost certainly qualify for a 1031 deferral of capital gains tax on property you sell when you reinvest in another investment property, as long as you follow the rules. Individuals, C corporations, S corporations, partnerships, limited liability companies, trusts, and any other taxpaying entities are eligible to participate in like-kind (1031) exchange. For more information from see the tips from the IRS on a 1031 Exchange.
What is the advantage of using a 1031 exchange?
Also known as like-kind or Starker exchange (Starker refers to the first tax case that allowed for these exchanges.)
A 1031 exchange can save you lots of money by allowing you to use the full amount of proceeds from the sale of one investment property for another, deferring taxes until the final cash sale. Take a look at this example that shows how a 1031 exchange can work.
- Assume an investor has $400,000 in gain and also $400,000 in net proceeds after closing. Assuming an investor with a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another property.
- Assuming a 25% down payment and taking on new financing for the purchase with a 75% loan-to-value ratio, the investor would only be able to purchase a $1,040,000 replacement property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.
So how complicated are the rules?
They are not extremely complicated, but they are precise and must be adhered to. For this reason, it is best to work with your realtor or business advisor who will know how to guide you through the process.
- You must exchange like-kind property. This refers to investment real estate. For example, you don’t have to buy another apartment complex if you sold an apartment complex. You can buy a different kind of investment property – like a strip mall. You may not use the proceeds to purchase a personal residence and still qualify for Section 1031. USNews.com lists the following examples of qualifying properties:
- Rental property for rental property
- Land for land
- Land for rental buildings
- Improved properties for non-improved properties
- Office buildings for condominiums
- Retail stores for apartment buildings
- Trailer parks for hotels
- 30-year or greater leasehold for land
- Tenant-in-common interest in real estate properties for rental buildings
- You have 45 days after the sale of one property to identify the next property you will be purchasing. You may present 3 different properties, as long as you end up closing on one of them. In certain circumstances, you may be able to present more properties if they pass the valuation tests.
- You must close on the next property within 180 days of the sale of the first property or your next tax return’s due date, whichever comes first. No extensions will be granted.
- You may use a qualified intermediary to handle the transactions. (If you choose to work with a 1031 Exchange Company, be sure they are insured to protect your money from disappearing in escrow.)
- Property cannot be sold to a related party for two years. A related party is defined as spouses, siblings, parents, children, or corporation or partnership where you own more than 50%.
What are the benefits of using a Like-Kind Exchange?
I’m glad you asked! The benefits can lead to a big reduction in your taxes, and increase the value of your commercial real estate investment. A 1031 Exchange allows you to continue growing your investments tax-deferred indefinitely. A 1031 Exchange can really help grow your real estate wealth.
For example, if you buy your first investment property, a piece of land, when you are 25, then sell it and purchase an apartment building when you’re 28, then sell the the apartment building and buy an apartment complex when you’re 34, then sell the complex and buy a strip mall when you’re 40, and so on, you won’t pay any taxes until you sell your final investment property when you retire.
At that point, the proceeds will be taxed at the long-term capital gain rate, which is currently 15%-20%.
If you don’t sell your investment property, and it becomes part of your estate upon your death, the property will be adjusted to its current value. Your heirs will not have to pay the long-term capital gains tax. If your heirs decide to sell the property and purchase another like-kind property, they can keep delaying the capital gains taxes. If you leave the property to one a particular heir, the related party restriction still applies.
Can I use a 1031 Exchange for my vacation home?
The answer is yes if you’re careful. You must rent the home for at least 6 months out of the year in an official capacity, meaning you are charging a fair rental fee and you have renters. If you wish to buy new investment properties, you must rent them at fair market value for at least 14 days in the following 2 – 12 month periods.
In other words, you must have them rented for at least 2 weeks in each of the 2 years following the purchase. Your personal use of the property cannot exceed 14 days or 10% of fair rental days, whichever is less.
Also, you must wait 5 years before selling the property as a personal residence in order to receive the tax credit personal residence sales. Here are some great tips for buying a vacation home.
What else should I know about 1031 Exchanges?
- Watch out for unequal transactions, mortgages, and other debt. If you sell an improved property and purchase an unimproved property, the depreciation capture is taxed as regular income. Also, if your liability goes down, even with no cash, the difference is still treated and taxed as cash.
- A like-kind exchange cannot be used for personal property. It is only for investment properties.
- Click here for the IRS Like-Kind Exchanges instructions.
- There is no limit to the frequency of which you use these exchanges. Exchange away!
Additional Helpful Home Buying Resources
- Why dual agency should be avoided in real estate. Via Realty Times
- What to know about buying into an HOA. Via Abraham Walker.
Use these helpful home buying resources to make smart decisions when buying a home.
Danny Margagliano is a real estate agent in the Santa Rosa Beach, Florida area, commonly referred to as 30A. If you are in the market for an investment property in Santa Rosa Beach you can reach Danny at 850-830-4747.