Clients often ask us about 1031 Exchanges. At face value, 1031 Exchanges allow smart real estate investors to defer their capital gains liability and build wealth. But like so many tax-efficient planning strategies, there are many rules and guidelines to navigate.
In this blog post, we cover what you should know if you’re thinking about doing a 1031 Exchange. And as ever, we would be happy to guide you through the finer points of the process.
What Is a 1031 Exchange?
Named after IRS code Section 1031, a 1031 Exchange is a loophole allowing real estate investors and businesses to swap one investment property for another. Unlike traditional real estate transactions in which a seller sells to a buyer and then buys from another seller, 1031 Exchanges depend on both parties wanting what the other has to offer. Once both parties reach an agreement, they will eventually exchange properties.
The main benefit of 1031 Exchanges is their tax-deferred status. Normally sellers pay capital gains taxes on their profits after closing the sale of an investment property. However, this loophole enables profits to be reinvested tax-free in the purchase of another investment property.
There is no limit to the number (or frequency!) of 1031 Exchanges an investor or business can do. This means profits from the sales of each investment property can be continuously reinvested in new properties. Once this cycle ends, the profits from the final sale are taxed at a single long-term capital gains rate. (As of 2020, this is 15% or 20% — depending on your income — or 0% if your taxable income is less than $78,750.)
When swapping one property for another, the two properties must be of “like-kind”. Based on the IRS definition, it is unclear exactly what “like-kind” means:
“Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. Real properties generally are of like-kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States.”
But in practice, you can use a 1031 Exchange to swap nearly any two investment properties within the United States, regardless of property type.
In addition, the rules and guidelines for 1031 Exchanges also leave room for interpretation…
Rules & Guidelines
Here are the rules and guidelines governing 1031 Exchanges at the time of writing:
Using An Intermediary
It is difficult to find another investor who has the exact property you want and vice versa. As such, most 1031 Exchanges are delayed and require the use of an intermediary. This person holds the proceeds from selling your property and uses it to “buy” the replacement property on your behalf.
Following Timing Guidelines
A 1031 Exchange requires you to meet certain conditions within a specified timeframe:
- 45-Day Rule: Within 45 days of the sale of your property, you must specify the replacement property in writing to the intermediary. You may designate three (or sometimes more) properties so long as you eventually close on one of them.
- 180-Day Rule: Within 180 days of the sale of your old property, you must close on the new one.
To be clear, the 45-day and 180-day exchange periods both begin as soon as your property sells. This means that the longer you need to designate your replacement property, the less time you’ll have to close the sale. However, due to COVID-19, the IRS announced a new extension; those in the middle of either the 45-day exchange period or the 180-day exchange period between April 1, 2020 and July 15, 2020 now have until July 15, 2020 to close.
Avoiding Depreciable Properties
If you exchange your property for another property that is underdeveloped or otherwise seen as a “depreciable asset”, this will trigger an event called a “Depreciation Recapture”. In this scenario, your profit would be taxed as normal income.
Establishing Primary Residence
If you wish to establish a property from a 1031 Exchange as your primary residence, you must be patient. Within the first 24 months following the exchange…
- You must rent the property to another person at a fair rental value for at least 14 days; and
- Your own personal use of the dwelling unit cannot exceed either 14 days or 10% of the number of days during the 12-month period that the property is rented (whichever is larger).
Using a property from a 1031 Exchange as a primary residence could also complicate your tax situation down the road. The IRS makes clear that living in the property means you will be delayed in receiving up to a $500,000 exclusion of your exchange profits subject to capital gains tax.
Converting Vacation Properties
Similarly, converting a vacation property into a 1031 Exchange-eligible investment property requires care. Let’s say you wanted to swap your beachfront residence for another property. You would need to move out, make it available to rent, and have tenants occupy the property for at least six months or (preferably) a full year. While there are no hard and fast rules about the duration of the rental, the longer you rent it out, the more likely the IRS will allow you to move forward with the exchange.
While 1031 Exchanges may limit your liability to a long-term capital gains payment, there are other tax implications to consider.
For example, it is common for these swaps to leave investors with cash left over. (This is the case when the property you purchase is of lower market value than the like-kind property you sold.) In this case, the intermediary will pay you the difference at the end of the 180-day exchange period. That difference, or “boot”, will be taxed as partial sales proceeds from the sale of your property, usually as a capital gain.
In addition, any reduced mortgage liability as a result of a 1031 Exchange will also be treated as taxable income. Suppose the mortgage on your old property was $500,000, but the mortgage on the new property is $400,000. That $100,000 difference is also considered “boot”, and will be subject to capital gains tax.
1031 Exchanges are indeed a great way for savvy real estate investors to limit their tax liability. However, there are many steps involved, and many unexpected pitfalls along the way.
For anyone interested in doing a 1031 Exchange, we would be happy to lend our expertise to make this as smooth a process as possible.
Here’s where you can learn more: