Savvy Investors Defer Capital Gains and Grow Their Wealth By Leveraging 1031 Exchanges

A 1031 exchange is a transaction that lets you exchange one real estate investment property for another while deferring capital gains taxes. The phrase “1031 Exchange” is derived from Section 1031 of the Internal Revenue Code (IRC).

1031 Exchange can be used to shield taxable gains for investment properties

Real estate investors must have a good grasp of IRC Section 1031's complex workings before attempting to exploit it. Internal Revenue Service (IRS) regulations restrict the use of an exchange only to like-kind properties and places limits in its use for vacation properties. Additionally, there may be issues with time constraints and tax ramifications.

KEY LESSONS

·A 1031 exchange provides a tax shelter. You can exchange a property that you have owned for business or investment reasons for a new one that you buy for the same purpose, deferring capital gains tax on the sale in the process.
You cannot receive the proceeds of the sale, even temporarily; they must be kept in escrow by a third party and utilized to purchase the new home.
For capital gains taxes to be deferred, the IRS must see the properties being traded as being of “like-kind.”
There is no cap on how frequently you may perform 1031 exchanges if used properly.
A previous principal house may be subject to the restrictions under very specific circumstances.

Section 1031 Defined:

A 1031 exchange, also known as a like-kind or Starker exchange, is generally the trading of one investment property for another. Most real estate swaps are taxable as sales, but if yours complies with 1031 regulations, you may have little or no amount of tax owed at the time of the exchange.

Essentially, you are permitted to change the form of your investment without (in the eyes of the IRS) cashing in on it or realizing a capital gain. This enables your investment to grow tax-deferred. You can perform a 1031 exchange an unlimited number of times. Gains from one investment property can be carried over to additional properties, and so on. Even though you might make money on each swap, you don't pay taxes on them until you sell the swap for cash in the future. If all goes according to plan, you will pay a single tax at the long-term capital gains rate, which is now 15 or 20 percent depending on income — and 0 percent as of 2022 for some lower-income taxpayers.

Most transactions only need to be of like-kind to qualify. The meaning of like-kind may perhaps be broader than one thinks. For example, you can trade a ranch for a strip mall or an apartment building for undeveloped property. Surprisingly liberal rules apply. One can even swap one business for another business, but there may be complexities to navigate in those instances.

The 1031 provision is typically for investment/business property, but there are some circumstances the rules can apply to a principal dwelling. There are also methods to leverage the 1031 exchange for vacation home swaps; however, this loophole is considerably more limited now than it once was.

Depreciable Property - Special Rules

When exchanging a depreciable asset, special regulations apply. Depreciation recapture is a type of profit that can be triggered and it is subject to ordinary income tax. You can generally prevent this recapture by exchanging one building for another. The depreciation you previously claimed on the building will be reclaimed as ordinary income, however, if you exchange improved land with a building for unimproved property without a building.

These difficulties are the reason to leverage expert assistance when conducting a 1031 exchange.

Rules and Timelines of the 1031 Exchange

A typical transaction involves exchanging one piece of property for another between two parties. However, there is a slim chance of finding someone who wants the identical property you have and has the precise property you want. As a result, many transactions are delayed, involve three parties, or are Starker trades.

A qualified intermediary, who holds the money after you sell your property and uses it to buy the replacement property for you, is required in a delayed exchange. This three-party transaction is considered a swap.

There are two timing requirements that must be observed in a delayed exchange.

The 45 Day Rule

The 45 Day Rule is concerned with designating a substitute property. The intermediary receives the money after your property is sold. A seller cannot directly receive or control this money otherwise it would invalidate the 1031 treatment. Additionally, a replacement property must be identified in writing to the intermediary within 45 days of the sale of your property.

According to the IRS, you are permitted to identify three replacement properties, as long as one of them is eventually closed. You may even choose more than three replacement properties if they meet specific valuation standards.

The 180 Day Rule

The 180 Day Rule relates to the closing of a designated replacement property. Once the previous property is sold, you must close on the replacement property within 180 days. The clock for the 45 Day and 180 Day time periods starts at the date of sale of your property. Even if you designate a replacement property on the 45th day, you do not get 180 days to close on it, but rather 135 days.

Reverse 1031 Exchange

It is possible to purchase the replacement property before selling your original property and still be eligible for a 1031 Exchange. The same 45-day and 180-day time periods apply in this situation.

To be eligible, you must transfer the new property to a qualified exchange accommodation titleholder, designate a property to exchange within 45 days, and finalize the transaction within 180 days of purchasing the replacement property.

Tax Implications of the 1031 Exchange

After the intermediary purchases the new property, there may be residual cash left over – referred to as the “boot.” In that event, the intermediary will transfer it to you at the conclusion of the 180-day period. The boot will be taxed as a portion of the proceeds from the sale of your asset, typically as a capital gain.

Investors commonly run into difficulty with these transactions if they fail to account for loans. Any debt on the replacement property, as well as any mortgage loans or other debt on the original property must be considered. Any reduction in liability - even in the absence of actual cash back - will be treated as income. For example, if you had a $500,000 mortgage on the previous house, but only a $350,000 mortgage on the new property, you would then have a $150,000 gain, which is likewise regarded as the boot and is subject to taxation.

Vacation Homes and the 1031 Exchange

In the past, taxpayers exploited the 1031 Exchange to swap one vacation home for another, possibly for a home where they plan to retire, and thereby delaying any taxable gain. They later moved in and made the new home as their primary residence with the intent to utilize the $500,000 capital gain exclusion in the future. As long as they live there for two out of the last five years, they can shield $500,000 in capital gain.

Congress closed that loophole in 2004. Taxpayers, however, can still use 1031 Exchanges and convert second residences into rental units. For instance, you might decide to stop using your beach house, rent it out for six to twelve months, and then swap it out for another piece of real estate. The house may then be considered to be converted from a vacation home to an investment property if you find a tenant and handle it as a business relationship, and in turn qualify for a future 1031 Exchange.

According to the IRS, renting out the vacation home without any tenants would make it ineligible for a 1031 Exchange.

Estate Planning and the 1031 Exchange

One drawback of 1031 Exchanges is that the tax break will ultimately end, leaving you with a hefty charge. There is, however, a workaround for this.

If you pass away without selling the property acquired through a 1031 Exchange, your heirs will not be liable for the delayed tax because tax obligations terminate with death. The property will also pass to them at its increased market value. As a result, a 1031 exchange can be extraordinarily beneficial for estate planning.

Reporting 1031 Exchanges to the IRS

1031 Exchanges must be reported to the IRS by submitting IRS Form 8824 along with the tax return for the year when the 1031 Exchange was conducted. Descriptions of the exchanged properties are required, as well as the dates the replacement property was identified and transferred, and the value of the like-kind properties. The adjusted basis of the sold property and any assumed liabilities or relinquished must also be disclosed.

What Is Depreciation Recapture Under the 1031 Exchange?

Investors can write off the costs of wear and tear of a property over the course of its useful life, and such depreciation allows real estate investors to pay lower taxes on the property.

The IRS typically recaptures some of these deductions and include them in the total taxable income when the property is eventually sold. By effectively rolling over the cost basis from the old property to the new one that is replacing it, a 1031 Exchange can help delaying that occurrence.

Conclusion

Smart real estate investors can employ a 1031 Exchange as a tax-deferred method of wealth accumulation. However, even experienced investors may find that the numerous moving pieces require professional assistance in addition to a clear understanding the rules.

Please feel free to reach out to the author discuss if you have any questions. ken@tribecagroupdfw.com | 202.256.9332

Real Estate Investors - Know the Rules of a 1031 Exchange!