It used to be that the term “Section 1031 Exchange” or even “Like-Kind Exchange” was uncommon except in certain circles. But as the idea of tax strategies have reached more and more taxpayers coupled with the housing market’s fluctuation in recent years, 1031s have become increasingly commonplace.
So, what is a 1031 Exchange? In its broadest terms, a 1031 Exchange is the trade of one investment property for another. When most people think of trading one property for another, we think in terms of selling one property, paying any applicable taxes and then buying a new property in a separate transaction. With the 1031, this is not the case. If your transaction meets the 1031 requirements, you will have limited to no tax due at the time of the exchange. In other words, you are changing your investment without cashing out or recognizing capital gains. This is a good strategy for someone that wants to remain an investor but may no longer have an interest in their current property portfolio. As there is no limit on the number of times you can perform a 1031 exchange, the investment you originally had will continue to grow tax deferred until such time as you eventually sell. This can provide time to create a sound plan and tax strategy for paying the long-term capital gain rate at the time of sale.
One thing to note, however, is that there are special rules pertaining to depreciable property exchanges. In order to avoid depreciation recapture, you must make sure that you are exchanging investments that retain the same structure. For instance, if you were to exchange improved land with a building utilized in an investment activity for raw land, you will incur recapture income. But if you were to exchange a rental property for another rental property, you would not, even though the rental has been depreciated. There will be basis adjustments for the exchanged buildings and your tax preparer should be informed of your intent so that they can help you strategize and prepare for the outcome. In addition to engaging your tax professional, you will also need the help of a 1031 Exchange Facilitator. Here are some things to think about when determining if a 1031 exchange is the right path for your investments.
In years prior, 1031 Exchanges could be used for a number of different types of properties – real estate, franchises, aircraft, and equipment. With the 2017 Tax Cuts and Jobs Act, only real estate still qualifies. And while the exchange of corporate stock and partnership interest is not exchangeable, some Tenants in Common (TIC) structures are. The TCJA does include a ruling that allows for the exchange of qualified personal property in 2018 if the original property was sold or the replacement property was acquired by December 31, 2017. There are limitations on this rule and a 1031 should not be entered into without understanding the full implications of the changes made by TCJA. 1031s are also not for personal use property. The property must be held for investment and while there are provisions that can allow you to exchange a vacation property, the loophole is much smaller and more difficult to obtain. With that in mind, the term like-kind is not as well defined as one might think in their own mind. You can exchange investment property (buildings, land, rentals) for other investment property. But there are traps for the unaware.
There are a few rules you must adhere to when performing a 1031 Exchange. The first are the timing rules. An important factor in 1031 Exchanges is that you do not receive the cash from the sale yourself. This will negate the 1031 treatment of the sale and create a taxable event. Therefore, you must designate an Exchange Facilitator prior to selling your initial investment property. The facilitator must hold the cash from the sale of the original property during the time period between the initial sale and the new purchase. You must designate the replacement property within forty-five days of the sale of your original property in writing to the facilitator. You can designate up to three properties and one of them must be the one that you purchase. You can also do a reverse exchange, where the replacement property is purchased before selling the exchanged property. (Note: Reverse 1031 Exchanges are far more complicated, and it is important to know the rule before engaging in one). The second timing rule pertains to the closing of the sale. You must close the sale of the new property (or old property in the case of a reverse exchange) within one-hundred and eighty days of the sale of the initial property. It is important to note that both of these time requirements run simultaneously.
Something to consider is the value of the two properties. If you proceed with a sale in which you receive funds after the purchase of the new property, those funds will be taxable to you. This is known as “boot.” Additionally, if you have a mortgage on the initial property and incur a lesser mortgage on the new property, the difference in liability is also considered boot and is taxable.
Another version of the 1031 exchange is the 1033 Exchange that relates to Eminent Domain Reinvestment. This occurs when the investor is required to relinquish property to the government through a force conversion. The IRS made provisions for this by creating the 1033 rules. The timeline for the exchange is extended to two to three years from the date of the forced conversion, giving the investor time to find the new property. Additionally, an Exchange Facilitator is not needed, and the funds can be placed in other shorter-term investments until the close of the 1033. The 1033 allows for the new investment opportunity to hold less value than the initial property without incurring the taxable boot.
Tax-deferred exchanges are very complex, even if you are a well-seasoned investor. Seeking the help of your tax professional and an Exchange Facilitator to go over the rules and consequences before attempting the exchange will provide for a better outcome in the long run.
Have a tax question? Contact Kazim Qasim.
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