A 1031 Exchange is also known as a Tax-deferred exchanged. It is used to defer taxes by commercial property holders who sell qualified property and reinvest the proceeds to acquire “like kind” property. The replacement property or properties must be a “trade-up” in value and not reduce the amount of debt.
Normally, when you sell a property, the taxes owed are due in the same tax year. A tax deferred exchange allows you to defer ordinary income, depreciation recapture and capital gain taxes on property used in the taxpayers’ trade or business or property held as an investment, as long as you meet the IRS rules or criteria. This is a huge saving when capital gain tax rates can be as high as 25%!
What Qualifies for An Exchange?
- Replacement property is “like kind”.
- The sale proceeds must only go through a qualified intermediary.
- All proceeds from the sale must be reinvested with the replacement property.
- The debt on the replacement property must be greater than or equal to the debt on the sale property.
- The replacement property must be identified within 45 days of selling. This rule is strictly enforced.
- The replacement property must be purchased within the exchange period. The exchange period is the earlier of 180 days after the initial property is sold or the due date for the tax payers returns for the property sold. This rule is also strictly enforced.
An investor who defers taxes with a 1031 exchange will have more capital to invest in the replacement property. This will allow the investor to acquire a higher value property than possible if taxes had to be paid out of the proceeds. Employing this technique over decades allows the investors to significantly increase the number of properties and wealth. If the investor passes the property to his children upon death, the children will have a new step-up in the cost basis to the current fair market value and eliminate the tax burden of the deferred exchange.
Many investors do not understand the IRS’s broad definition of “like kind” as used in the exchange. Vacant land could be exchanged for an apartment building. An apartment building could be exchanged for a ranch. An office building could be exchanged for a hotel or retail space. This broad definition of “like kind” helps the investor to accomplish diversification, consolidation or increase cash flow in selecting properties. The 1031 exchange can also be used to consolidate holdings or multiply holdings. Properties outside the USA are not considered “like kind”.
Replacement Property Rules:
3-property rule: Most exchanges use this rule where you identify any three properties as possible replacements for your relinquished property.
200% rule: This rule allow you to identify any number of properties as possible replacements for your relinquished property as long as the total value of those properties does not exceed 200% of the value of your relinquished property.
95% exemption: This rule allow you to identify any number of properties as possible replacements for your relinquished property as long as you end up purchasing at least 95% of the total value of all properties identified.
Why pay taxes when you don’t have to? Obtaining an experienced qualified intermediary is essential to making the deal work. The IRS rules must be strictly adhered to. The 180 day and 45 day rules are strictly enforced even if they fall on a holiday or weekend. The qualified intermediary may not be a fiduciary or agent of the investor (attorney, realtor, CPA). The exchange regulations can be complex and failure to follow the requirements can result in the transaction being invalidated and result in taxes and penalties.
Disadvantages of a 1031 exchange
Lower Tax Basis
After executing a 1031 exchange, the tax basis on the replacement property is reduced by the amount of the gain deferred. Should the investor sell the property, then the previous deferred gain will be taxed.
Future Tax Rates
If tax rates increase in the future, your deferred gain will be taxed at the higher rate; when you sell the replacement property.
Can my Vacation Home Qualify as a 1031 Exchange?
If your vacation home is not rented and is used as a second home, the IRS has ruled that it does not qualify as a 1031 exchange. However, you can convert a vacation home to qualifying status by making it an investment property. First, don’t use the home for two years prior to selling it. Next, rent the property yourself or place it with a property management company to establish it in a rental program. If you rent it to friends or relatives be sure to charge market rent. The property must be rented to a non-relative for a minimum of two weeks. Do not deduct home mortgage interest on your taxes. If you have rental income, deduct the mortgage interest on schedule E or schedule A as investment interest.