082: What is a 1031 Exchange?

SHOW NOTES FOR EPISODE 082–WHAT IS A 1031 EXCHANGE?

Many people who sell an investment property believe that federal capital gains from that sale must always be handed over to the IRS.  This is not always the case.  IRS Code Section 1031 offers investors the opportunity to reinvest federal capital gains from a sale if you swap that property for another…and it does not always have to be for ‘like property’ either!  Instead, as an investor, you could have that money work for you rather than end up in the hands of the IRS. Further, you do not have to sell your property for the exact same type of property either!

The 1031 Code indicates that no gains or losses will be recognized on the exchange of any type of business use or investment property for any other business use or investment property.

How do you define a 1031 Exchange?

According to Investopedia, a “1031 Exchange” is a section of the U.S. Internal Revenue Service Code that allows investors to defer capital gains taxes on any exchange of “like-kind” properties for business or investment purposes. Taxes on capital gains are not charged on the sale of a property if the money is being used to purchase another property – the payment of tax is deferred until property is sold with no re-investment.

BREAKING DOWN ‘Section 1031’

The idea behind this section of the tax code is that when an individual or a business sells a property to buy another, no economic gain has been achieved. There has simply been a transfer from one property to another.  For example, if a real estate investor sells an apartment building to buy another one, he or she will not be charged tax on any gains he or she made on the original apartment building. When the investor sells the original apartment building and purchases a new one, the value used from the original to buy the new one has not changed – the only thing that has changed is where the value is being held.

So what does this mean?  How can this help you?

If you own a business or an investment property you should consider a 1031 exchange.   You would be able to defer 100% of both federal and state capital gains tax.  1031 Exchanges, in essence, become interest free loans; where the principal may increase through future exchanges allowing the Exchanger to never pay back, if the transactions are planned well.

Sometimes, people think it’s more complicate that it is and they just say forget it, “I will pay the capital gains taxes and avoid the hassle” but it is not as complicated as it may seem.

If you are you apprehensive about  1031 Exchanges, here are some interesting facts, which will make the decision easier.

1) At one time, exchanges were only done to switch “like investment properties” to the same person swapping for your own, but this is not the case anymore.  In fact, you can sell your own property to someone who does not have a relationship to the person from whom they are purchasing the replacement property.

2) It is important to know that “like-kind”properties once meant the same, condo for condo, empty lot for empty lot but that is also no longer the case.  If you have invested your money in an empty lot but wish to exchange for an apartment building, this too is possible and again, no taxes would be paid for the sale of the vacant land when following the guidelines of the 1031 exchange.

Like-kind refers to the nature of the investment rather than the form.  Any type of investment property can be exchanged for another type of investment property.  A single-family residence can be exchanged for a duplex, raw land for a shopping center, or an office for apartments.  Any combination will work. The exchanger has the flexibility to change investment strategies to fulfill their needs.

3)  Many believe only investors of large commercial properties can utilize a 1031. One of the greatest features about a 1031 Exchange is that it applies to all investment properties, large and very small. A 1031 Exchange works the same way for a corporation selling a large shopping mall as it would for an individual selling a single-family property used for rental or held for investment in a resort area.

4) Many believe 1031 Exchanges are very complicated and not worth investigating.  Consider working with a qualified intermediary who can offer you professional advice and direction.  1031 Exchanges are a relatively smooth process and definitely worth considering but sound advice from an experienced professional is important.

5) The Exchanger can acquire a replacement property with greater income potential.  For example, raw land can be sold to acquire income-producing property or a larger or more ideally located property.  A duplex rental property can be exchanged for a 4-family investment property offering greater income.

1031 Basics

1. Why would someone want to do a 1031 Exchange?To defer capital gains tax on the sale of commercial, business, or investment property.Q.Is a 1031 Exchange a gimmick or loophole in the Internal Revenue Code?

   No.  Section 1031 has been a part of the Internal Revenue Code since the inception of the Code, during the 1920’s.

   Q. What type of property is not eligible for a 1031 Exchange?

   Your residence is not eligible for 1031 treatment.  Any other property that is not held for commercial, business, or investment purposes is also not eligible.

   Q. Is 1031 only for capital gains?

   No.  Section 1031 applies to capital gains taxes (15%), depreciation recapture (25%), and state income taxes (generally 8% to 9% where applicable).  Long-term capital gains taxes apply to property held over 1 year – gains from property held less than a year are typically taxed as ordinary income.

   Q. How do I start a 1031 Exchange?

   You must contact a Qualified Intermediary before you sell your property, so that you can complete the appropriate documentation and structure the exchange.

Qualified Intermediary

1. Do I have to use a Qualified Intermediary?Using a Qualified Intermediaryis the most common way to receive ‘safe harbor’ protection for your 1031 Exchange.Q. Can’t my own attorney or CPA serve as my Qualified Intermediary?

   No.  A Qualified Intermediary must remain completely independent and cannot have been your agent in the past 2 years.

1031 Timeframes

1. Do I have to know what property I will be purchasing when I start the exchange? No. You have 45 days from the sale of your relinquished property to identify your potential replacement properties.Q. How long do I have to purchase my replacement property?

   You have 180 days from the sale of your relinquished property by which you must close on the purchase of your replacement property/properties.

    

Property Identification

1. How many potential replacement properties may I identify?• 3-property rule: You may identify up to 3 properties without regard to their value.
   • 200% rule: You may identify more than 3 properties provided that their combined fair market value does not exceed 200% of the value of the relinquished property.
   • 95% rule: You may identify any number of properties, provided that you acquire 95% of the fair market value of those properties.

Napkin Rule

1. Do I have to acquire a property of equal or greater value? Yes, in order to completely defer the applicable capital gains tax. To the extent you purchase a property of lesser value, you will be taxed on the difference. (See Napkin Rule)Q. Do I have to use all the cash proceeds from my sale on my purchase?
   Yes, you must use all cash proceeds from the transaction in order to completely defer the applicable capital gains tax.  To the extent you do not use all your proceeds on the purchase, you will be responsible for any tax on the difference.

   Q. Do I have to obtain a mortgage on my replacement property in the same amount or same percentage of debt as I had on my relinquished property?

   No.  Just follow the above rules.

   Q. Does Seller Financing jeopardize my exchange? 

   Seller Financing is considered boot, which means it is taxable in the year(s) that it is paid (considered an ‘installment sale’). There is a possibility that the Seller Financing (Note) can be placed into the exchange without paying taxes, but the note would have to be paid off or sold before the purchase of the replacement property.

Construction Exchanges

1. May I purchase replacement property that is not yet built?Yes, you may purchase replacement propertythat is not yet built, provided that the improvements on the property are completed prior to the expiration of the 180 days.  This is a Construction Exchange with greater complexity and fees. In a Construction Exchange, the property is held by a specially formed LLC called the EAT (Exchange Accommodation Taxpayer).

Exchanger: Partnerships/Corporations/Individuals

1. May a corporation or partnership be involved in a 1031 exchange?Yes, provided the entity selling the relinquished propertyis the same as the entity purchasing the replacement property. Corporations or Trusts that are 100% owned by the same entity are considered “Disregarded Entities”, and the same entity for 1031 purposes.Q. Are there any age restrictions on the exchanger (i.e. are people over a certain age exempt from paying taxes)?

   No.

Relinquished Property – Holding Period

1. How long must I hold my current property in order for it to qualify for a 1031 Exchange? Property involved in a 1031 Exchangemust be held for “investment or productive use in a trade or a business.”When looking at “investment intent” the courts will often look to the period of time over which the property is held. That said, there is no specific holding period requirement for either the relinquished or replacement property.

   Taxpayers who hold their relinquished property for two years satisfy the requisite intent for a 1031 Exchange (or two tax reporting periods, since in an audit the IRS may look backwards and forwards two tax returns).  A holding period of over a year has generally been accepted, but may be subject to review by the IRS. A much shorter holding period has been accepted, where a change in circumstances indicates that the taxpayer had intended to hold the property for a longer period. The IRS will look at ‘investment intent’ and will call a taxpayer quickly flipping property a ‘dealer’ vs. an ‘investor’.

Relinquished Property – Personal Residence

1. May I use my personal residence in a 1031 Exchange? No. If, however, a portion of your property is held either for productive use in a trade or business or for investment, that portion may be eligible for 1031 Exchange treatment.Q. What if I live on part of the property?

   The taxpayer can split the transaction between 1031 Exchange and the personal residence exemption (Section 121:  $250,000 for an individual or $500,000 for a married couple).

   Q. What about a Second Home?

   If the taxpayer has claimed the residence as a second home on their tax returns, they likely cannot consummate a 1031 Exchange. If the taxpayer has lived in the residence over two weeks, the residence is a second home and will not qualify for 1031 treatment. The two weeks can be longer if 10% times the number of days that the residence is rented a year is more than two weeks.

   Example 1: a residence rented 83 days cannot be lived in by the taxpayer more than two weeks.

   Example 2: a residence rented 200 days cannot be lived in by the taxpayer more than 20 days.

   Q. May I do a 1031 Exchange, and later move into the replacement property as my personal residence?

   You cannot purchase the replacement property with the intent to move into it as a personal residence. If, however, you hold the replacement property for a sufficient time to establish the requisite intent for a 1031 Exchange, then you may move into the property and thus change the nature of the use of the property.

   After moving into the property, a taxpayer may look to take the Section 121 exemption for personal residences. Under the recently enacted law, to gain the 121 exemption, the property must not have been the subject of a 1031 Exchange in the previous 5 years (that is, 5 years from the closing of the phase 2 acquisition).

Relinquished Property – Foreign Properties

1. What about foreign properties?Property within the United States must be exchanged for property within the United States. Property outside the United States can be exchanged for property outside the United States, but not with property within the United States. The United States, for purposes of §1031, includes the U.S. Virgin Islands, if you are doing business there.

Relinquished/Replacement Property – Incidental Costs

1. What costs or fees are reimbursable to the taxpayer?Any costs or fees that are incidental to the sale or purchase. Fees associated with loans, rental deposits, etc., must be covered by cash in the purchase of the replacement property, or will be considered boot.Q. What happens when I need to make a down payment on my replacement property? 

   Your Qualified Intermediary may directly wire the down payment from the funds held on your behalf.  Alternatively, you may make the down payment and be reimbursed at the closing of the purchase of your replacement property.

Well, that’s it for today.

Please note:   I am not licensed nor qualified to provide legal and/or tax advice, the statements made in this podcast should be verified with your own competent tax and/or legal advisor who has specific information about your particular situation.  You should only rely on your own competent tax and/or legal advisor’s advice.  Nothing noted above is tax and/or legal advice.  The above information is general in nature and is for general informational purposes only.

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