IRS SECTION 1031 - TAX DEFERRED EXCHANGE
Another popular avenue for funding a real estate investment is utilizing a 1031 tax deferred exchange. During the last recession when appreciation was non-existent there were no gains for buyers and sellers to defer but in the current market, the use of the 1031 has made a strong return.
As a 1031 exchange is a handy tool for deferring income tax on the sale of real estate, I thought you might desire more details about the program. As typical for any IRS code, the description material tends to be dry so reading this article may function as a sleep aid as well.
What is an IRS Section 1031 Tax Deferred Exchange? Quite simply, it allows you as the owner of investment property (almost all property that is not your personal residence or second home) to sell the property and buy another investment property, deferring the tax on your capital gains. You do not have to find someone to accept your property in trade for the one you sell. A simultaneous close is not required.
The investment property being relinquished must be owned by the exchanger for a least 24 months prior to the exchange and must have been held for investment purposes during that entire holding period. You must keep good documentation to evidence the “held for investment” purposes. Further, the owner can not violate the fair market rental and personal use of the property rules.
The new property acquired by the exchanger must also be used as an investment property for at least 24 months after the acquisition. Some articles I have read state 12 months is adequate, if it shows on the exchanger’s tax file for 2 filings; timing is important.
During the holding period the property, if rented, it must be at fair market rental rates and the exchanger’s personal use of the property must not exceed the greater of 14 days or 10% of the time the property is rented out at fair market rent during a 12-month period.
This is workable with a vacation rental especially when time spent by the exchanger at the property to make repairs is not counted as personal use as long as it meets the rules. The exchanger must work on the maintenance and repairs the lesser of 8 hours or 2/3rds of the time the exchanger is on the premises. This is a tricky area so you should check with your CPA about the documentation required.
You should also check with your CPA about renting to family members, it is possible, but you want to make sure you are well documented.
The steps for performing an exchange are not significantly different from those for completing a standard sale. You list the property, hopefully with me, and then market it for sale just like any other property. A Buyer is located, and escrow is opened. A 1031 Intermediary is brought into the transaction prior to closing. The existing property is closed but the net proceeds are held by the intermediary. When a suitable replacement property is closed, and the exchange is concluded.
When considering the sale of income or investment property, you as a seller must consider the taxation. When selling property, you could owe federal and, in some areas, state capital gains tax. This could mean paying 20% to 40% in taxes on the gain. Instead of paying a large amount to the IRS in taxes you can use that money to buy more real estate. Property that qualifies for preferential tax treatment under Internal Revenue code section 1031 (IRS 1031) is treated quite differently. IRS Section 1031 states:
"No gain or loss shall be recognized if property held for productive use in a trade or business or for investment purposes is exchanged solely for property of a like-kind". Investors do not have to exchange for exactly the same type of property as they relinquished. "Like-Kind" does not refer to the nature, character, or type of property, but just that it also be held for productive use or for investment purposes.
Therefore, if using IRS section 1031, you can exchange raw land for a rental home, an apartment complex, or for a shopping center. The use of the property is the factor in determining the tax treatment and the property must have been initially acquired and held for either business or investment purposes.
You must trade "equal or up" in equity and value to completely defer taxes. If you dispose of a property at one value and acquire another property at a lesser value, taxes are due on the difference. You may purchase up to three different replacement properties.
No cash can be received from the transaction (boot), whatever cash is received is taxable. In a 1031 exchange, receipt of cash cannot be offset with a larger debt.
When can dispose of property, you have 180 days to acquire another property; the pressure of trying to structure simultaneous closings no longer exists. You are not required to find replacement property which can close the same day of the property being sold. The delayed exchange begins when you enter into a purchase contract. After the first closing, the exchange clock starts ticking. From the settlement date you have 45 days to identify replacement property. From the sale settlement date, you have 180 days to actually acquire one or more of the identified properties.
These regulations also require the use of a qualified intermediary in deferred exchanges. Use of a professional Intermediary with no other relationship to the exchanger provides you the mandatory "Safe Harbor" to perform a non-taxable sale.
An Intermediary is substituted, into the contract to sell the property. In theory, the Intermediary becomes the seller, but the sale is reported on the tax ID number of the Seller. This is perfectly legitimate under the Treasury guidelines written to clarify Internal Revenue Code Section 1031.
The sale will not be delayed; the buyer will purchase the property for the same contracted price. But instead of paying taxes on the sale, if you follow the rules, you save 100% of the net equity available for purchasing a replacement property.
When a replacement property has been found and an offer accepted, the Intermediary will again be substituted as the Buyer of the new property to complete the exchange. The intermediary will use the proceeds from the sale of the original property to purchase the replacement property. The intermediary holds your sale proceeds during the exchange period, and you generally will earn interest on these funds.
Further, the code procedure allows you to acquire investment real estate now, when an excellent investment may be available and to sell your property later, when a better price might be obtained, so long as this all happens within 180 days. This is called a reverse exchange. This procedure greatly expands your ability to take advantage of changes in the marketplace and to improve your investment position.
The IRS allows the deduction of brokerage commissions from exchange proceeds as they reduce the amount of equity the taxpayer realized. The IRS requires that only the net equity be transferred to the replacement property.
After holding the replacement property for 2 years and not violating the fair market rental and personal use requirements, the replacement property may be converted into a primary residence, secondary residence, or vacation property. When you ultimately sell the replacement property you have converted into a residence, you may be able to exclude all or a portion of the gain on sale provided that you have owned the property for at least 5 years total.
When working with IRS, document, document, document is the rule.
This material is intended to be informational and is not all inclusive; no effort has been made to summarize all of the requirements and issues that may be applicable to a particular situation. This material should be not used as a substitute for independent financial or legal advice. Please consult with your CPA or tax advisor.
Merri Ann Simonson – Managing Broker
Coldwell Banker San Juan Islands, Inc.
Posted Feb 2022