Taxes rarely make for exciting reading material, but if you own an investment property, there’s at least one set of IRS regulations you absolutely will want to understand: 1031 exchange rules. Why? Because normally when you sell an investment property for more than what you paid for it, you’d have to pay a hefty capital gains tax. But with a 1031 exchange, you get to defer paying those taxes if you reinvest the proceeds in a new property, making an “exchange” rather than a sale.
It’s just that this transaction is subject to some strict regulations, so you’ll need to follow the 1031 exchange rules to the letter. There are many investors who would like to do a 1031 exchange. Some of them who do fix and flip call us for a 1031 exchange to roll the gain over into the next property. But can they? Although confusing, understanding IRS Code Section 1031 is worth it. Here’s what you need to know to pull it off.
Definition: A 1031 exchange is an exchange of two (or more) pieces of real estate under Section 1031 of the tax code. A simple definition of 1031 exchange properties is the property being sold and the property being purchased in accordance with Section 1031 of the tax code. In the simplest case, you’re swapping one property for another. It can come with high legal fees and strict limits.
However, this is often worth it, given the great benefits of a 1031 exchange. This explains why the 1031 exchange is used by businesses to “move up” in buildings, selling their existing ones to buy a larger facility with minimal taxes. Although, a 1031 exchange process is complex it is one of the best tax advantages real estate investors have at their disposal.
When To Do a 1031 Exchange & Its Benefits?
A 1031 tax-deferred exchange allows you to roll over money from a recently sold investment property into another property. You’re able to defer capital gains taxes on the property’s sale. This tax rate will range from 15 to 30 percent. Suppose you own a rental house. Sell that property and use the money to buy two more rental houses. You’ve avoided a capital gains tax bill on the profit for that property, and you’ve used it to buy two more.
Continue growing your portfolio over the years. You could continue to buy rental houses, or you could sell the properties and buy an apartment building. The 1031 exchange rules will let you roll the capital gains for 10 houses into a large multi-family project. You could in theory continue this until your death, potentially avoiding capital gains taxes until your estate has to deal with it.
Another benefit of a 1031 exchange is that it resets the depreciation clock. You’ll be able to buy a new property and take advantage of depreciation to offset your income. This can really add up if you’re selling a property that you’ve held for more than two decades. If you sell an investment property for more than its depreciated value, you will probably have to recapture the depreciation. This normally results in the amount of depreciation included in your taxable income. A 1031 exchange avoids taxes on this amount that may exceed the official capital gains.
When do people want to do a 1031 property exchange? The most common situation is when you want to avoid paying capital gains on the sale of a property. It may be done when you’re consolidating your real estate portfolio, selling multiple properties to invest in a single larger building. Or it may be done when you’re liquidating one property and investing in several more.
Also, if you have invested in properties that are low-income and high-maintenance, you could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another without the IRS knocking at your door.
Is 1031 Exchange Possible When There Are Losses Involved?
The goal of 1031 property exchanges is to avoid paying capital gains taxes on the sale of the property. In most cases, the 1031 exchange properties have a greater value than the one that was just sold. This may involve a more expensive home or a larger, multi-family unit. However, a 1031 exchange is possible when there are losses involved. Section 1031(b) specifically addresses cases where the transaction results in a loss.
The financial loss is not recognized at the time of the transaction. Instead, it is carried forward as part of a higher basis on the property you’ve received. Note that you can sell a property that you’re losing money on and roll the money into a new property as part of a 1031 exchange. The full benefit requires the replacement property to be of equal or greater value than the one you’re selling.
And if you’re selling a flooded house or property where the tenant isn’t paying the rent, almost anything you buy is a step up. If you are trading down in the property, you may get a “boot” in the form of debt reduction. Other forms of “boot” include prorated rent, utility escrow charges, service costs other than closing costs, and deposits transferred to the property buyer.
That money can be offset with cash used to purchase the replacement property. The boot used to include non-like-kind property including livestock, industrial equipment, and vehicles. This means you can’t count the value of animals on a farm or equipment in a factory towards either losses or gains in a 1031 exchange. Consult with a tax professional to understand your options for avoiding a capital gains tax bill if you receive money like this.
The Tax Cuts and Jobs Act of 2017 mitigated losses of 1031 exchanges by giving taxpayers the ability to immediately deduct certain expenditures. This might be classified as either a “bonus deprecation” or a business expense.
Here is an example to understand this type of 1031 exchange.
Before you make any decisions, it is important that you know the “adjusted basis” of your property. As the term implies, over time you adjust the basis in a property. If the “adjusted basis” is less than what the property is sold for, then we have a “total gain”. If the adjusted “tax basis” is more than what we sell the property for we have a true loss in the eyes of the IRS.
The adjusted basis is calculated by taking the original cost, adding the cost for improvements and related expenses, and subtracting any deductions taken for depreciation and depletion. Suppose you buy a $150,000 home. When determining the basis, start with this $150,000 and add any associated fees such as real estate taxes the seller owed that you paid as part of the transaction. This figure is your basis. To get your adjusted basis, add or subtract any associated costs or credits.
For example, if you invested $50,000 in home renovations, add this $50,000 to the basis to get an adjusted basis of $200,000. If you had storm damage to your home and had to pay $5,000 for roof repairs, add this amount to get an adjusted basis of $205,000.
If you do a 1031 exchange, all the total gain, including the tax on recaptured depreciation, will be deferred. If you exchange property with a true loss, then the loss amount is added to the basis of the replacement property. A simple example would be if you had a vacation area lot that cost us $200,000 that we sold for $100,000 and exchanged for a $100,000 lot close to your home.
You would have a $100,000 loss in the eyes of the IRS and would add your loss to the new basis of your replacement property. Because of the exchange, the new lot would have a starting basis of
$200,000, even though you only paid $100,000 for the lot.
While these rules are complicated, they must be followed—there are no exceptions or extensions. If you mess up, the IRS could decide you don’t qualify for a 1031 exchange and send you a huge tax bill. So make sure you know how it works. If you’re in doubt, consult an accountant or real estate agent for more details. For more information on 1031 exchanges, go to IRS.gov.
Examples To Understand a 1031 Exchange
Let’s look at a few examples to understand what this means in practical terms. In the classic swap, you sell a rental property you bought for 150,000 dollars for 200,000 dollars and rollover the money into a 300,000 dollar duplex. While you’ll owe closing costs, legal fees, and a few other expenses out of pocket, you avoid paying capital gains taxes on the 50,000 profit. That would result in a 5,000 to 10,000 capital gains tax bill depending on where you live.
What happens if you have a property you’re going to take losses on? You bought a beach house at the peak of the market a decade ago for half a million dollars. You’ve maintained it but haven’t taken steps to increase its value. The area is in decline, so the property is only worth 400,000 dollars. Then you finally get a good offer. Someone is offering you 450,000 dollars for the property.
From your perspective, this is a loss. From the government’s perspective, you’ll owe taxes on the 50,000 gain including the recaptured depreciation. If you do a 1031 exchange when selling this property, the theoretical gain and recaptured depreciation are deferred.
Important Rules For A 1031 Exchange
There are several rules that need to be followed while doing a 1031 exchange. Rules related to tax implications and time frames that may be problematic. If you’re considering a 1031 exchange, here is what you should know about all the rules.
If you decide to do a 1031 exchange, once the money from the sale of your first property comes through, it will be held in escrow—an independent account monitored by a third party. You won’t be able to access the money until you close on a new property.
Note that you’re not allowed to use the money from the 1031 property exchange for anything else. You can’t sell two commercial 1031 Exchange properties, do two quick fixes and flips and then roll the proceeds into a new apartment building. The money from the first transaction will be held by a qualified intermediary who acquires the replacement property for the taxpayer. And this is fine, provided you follow a few more rules.
Like-kind properties rule: 1031 exchanges must be done with like-kind properties. The rules for like-kind properties have evolved over the rules. In 1984, Section 1031 of the tax code was changed so that the definition of like-kind was dramatically expanded. You now had the option to sell a rental house and buy a small apartment building. Before the rule change, you didn’t just have to trade a house for a house but a three-story apartment building for a three-story apartment building.
The properties don’t have to be in the same sector. For example, you could sell an apartment building and invest the proceeds in an industrial building. International and domestic properties are not “like-kind” 1031 exchange properties, either. Yet you can use almost any property in the United States for a 1031 exchange. However, it is very important that if you cannot find the right property to reinvest the proceeds, don’t do a 1031 exchange. You should avoid buying the wrong property at the wrong time in the housing cycle.
Three-property rule: You can identify up to three potential properties to buy as long as you close on at least one of them. The federal government limits the rollover process to up to three properties. Most investors limit themselves to up to three properties to avoid being subject to more complex tests or simply minimizing the necessary paperwork.
200% rule: You can identify any number of replacement properties you want to purchase so long as their eventual combined fair market value isn’t more than 200% of your relinquished property. So let’s say you sell a property for $500,000. The combined market value of your purchase should be no more than twice that, or $1 million.
95% rule: You can ignore the 200% rule and identify any number of potential replacement properties for any amount as long as you buy 95% of the aggregate value of those properties. So if you sold a property for $500,000, you could identify five properties worth a total of $2,500,000. But you’d then have to actually buy at least $2,375,000 (that’s 95%) worth of those properties.
45-Day Time Limit to find a 1031 Exchange Property: The 1031 exchange used to have to be done nearly simultaneously. This caused a variety of problems because it can be hard to transfer titles and funds in a short period of time. However, the current 1031 exchange process still has a time limit. There is a strict 45-day time limit. You must either close on or identify and report on the potential replacement property within 45 days of selling the original property. This time period includes weekends and holidays. If you pass that time limit, the entire exchange is disqualified. The IRS won’t interfere in the purchase of the new property. However, you’ll owe taxes on the sale of the old one.
180 days for the transfer to complete: After the sale, the clock starts ticking for you to find that new property: You have 45 days to identify a new property (or properties) you want to buy. Once the replacement property is selected, the investor has 180 days from the date the original property was sold to close on the replacement property. Since closing on a property can take time and is often unpredictable, many investors choose more than one property to buy with the hopes that at least one of them will come through.
Personal residences do not count as 1031 exchange properties: You can’t sell your personal residence and use part of the money to buy a rental. A general rule of thumb is that you can’t use a 1031 exchange if you lived in it for at least two of the past five years. Vacation homes and second homes typically don’t count, either. Paragraph 280 of section 1031 outlines the usage test that can be used to determine if a vacation home you rent out periodically can be included among 1031 Exchange properties.
Fix and flip properties don’t count as 1031 Exchange properties: To qualify for a 1031 exchange, both the new and old properties have to be held as an investment or used in a trade or business. Held for investment means holding the property for future appreciation. Used in a trade or business means income-producing, such as used in a business or used as a rental property. A fix and flip kind of property is regarded as property held for sale. You may be able to count it as a 1031 exchange if you end up renting it out for a few months before selling it to an investor.
Land that you’re developing is not qualified for tax-deferred treatment under section 1031 of the tax code, though raw land might: A 1031 exchange can include build-to-suit exchanges, but the construction and property improvements must be completed by the 180-day time limit. In general, your interest in a partnership doesn’t count under section 1031. If you receive non-like-kind property like liabilities or cash equivalents, this could result in a tax bill. After 2018, the 1031 exchange could only include real property. Yet the exchange can include money such as proceeds after a mortgage is paid off.
Who Qualifies For a 1031 exchange?
Here are the basic requirements according to Los Angeles accountant Harlan Levinson:
The homes must be investment properties. This transaction is not for regular homeowners who live in the home they’re selling (or buying). Both homes in question must be investments, whether you plan to (or did) rent it out to tenants or flip it after renovations.
The home you buy must be worth more than the one you sell. People benefit from a 1031 exchange only when the property they buy is of equal or greater value than the one they’re selling—in other words, they’re trading up. For instance, maybe you bought a quaint summer cottage rental, but you want to cash that in for a larger mansion on the beach, or a duplex where you can rake in rental money from two families rather than one. If you intend to pay less for a new property, you’ll pay taxes on the difference.
How to Do a 1031 Exchange?
There are several initial steps to a successful 1031 exchange process. For example, you’ll want to find a qualified intermediary before you sell the property. Then there is the process of listing the property you want to sell.
The first official step in the 1031 exchange is selling the first property. It is advisable to have potential replacement properties identified at this point. However, you don’t have to close on these properties immediately. If the 1031 exchange properties cannot be closed simultaneously, the money must be held by a qualified intermediary. This means the taxpayer doesn’t receive the money from the sale of the first property.
The second step in a 1031 exchange is formally identifying your replacement property. This must be done within 45 days of the sale date of the first property. Ideally, you’d have begun the purchase process.
The third step of the 1031 exchange process is to complete the purchase of the replacement process including payment and retitling of the property. The facilitator will hold the cash from the sale of the first property and send it to the seller of the replacement property. Then the 1031 exchange is treated as a swap by the IRS and considered done once you fill out the IRS form.
In general, you have 180 days from start to finish. However, you may have to do so even faster. For example, you generally have to complete the process before you file your tax return claiming the 1031 exchange. This means you’ll want to complete the 1031 exchange started last tax year before you file your tax return the following April.
If you actually acquire the replacement property before the first one sells, this is called a reverse exchange. The property must be held by an exchange accommodation titleholder. This could be a qualified intermediary. You’ll get the title transferred to you when the first property sells.
What happens if there is money left-over after the new property has been purchased? Maybe the new property costs less than you expected after all costs are taken into account. Or you didn’t use all of the money toward the purchase of a new property. A tax penalty will be owed, but it is typically only for the amount that wasn’t rolled over into the new property.
Conclusion
The savings of the 1031 exchange are so substantial that it is used by businesses and real estate investors alike to save money. The biggest reasons why people don’t take advantage of them are because they either want to reduce their exposure to real estate or can’t find a good replacement property in time.
References:
What is a 1031 Exchange?
https://en.wikipedia.org/wiki/Internal_Revenue_Code_section_1031
https://fundrise.com/education/blog-posts/opportunity-fund-1031-exchange-tax-advantages-for-real-estate-investors
When to do a 1031 Exchange & what are the benefits?
https://www.thebalance.com/how-to-do-1031-exchanges-1798717
https://www.cwscapital.com/what-is-a-1031-exchange/
The Rules for a 1031 Exchange
https://www.1031.us/PDF/1031ExchangeIfSellAtALoss.pdf
https://www.law.com/newyorklawjournal/2020/06/23/proposed-regulations-for-section-1031-exchanges/
https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips
How to Do a 1031 Exchange?
https://www.fool.com/millionacres/taxes/1031-exchanges/#
https://www.buildium.com/blog/what-is-a-1031-exchange/
https://www.thestreet.com/personal-finance/real-estate/what-is-a-1031-exchange-14881004
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