1031 Exchanges

1031 Exchange Webinar/Seminar Recording - June 11, 2022

1031 Exchange - Basics

The name 1031 exchange is taken from Internal Revenue Code Section 1031. For real estate, a 1031 exchange is a swap of one or more investment/business properties for one or more different investment/business properties that enables capital gains taxes to be defered. Typically one or more properties are sold, then one or more properties bought. It is possible to do a reverse 1031 where a property is bought then an already owned property is sold.

• A 1031 exchange is a swap of properties that are held for business or investment.
• The properties being exchanged must be like-kind to achieve a tax deferal.
• There is no limit on how often nor how many times you can do 1031 exchanges.
• Title to the relinquished property must be in the same taxpayer name as the purchased property.

Like-Kind Properties

Like-kind has a broader meaning when doing a 1031 exchange of real estate than many realize. You can exchange an apartment building for raw land, a ranch, or even a strip mall. However, both the property being sold and the property being bought must be in the United States.

If you want to use either a primary residence or a vacation home in a 1031 exchange, you must first use it as an investment or business use. There are fairly strict requirements.

An Exchange Accomodater / Exchange Intermediary

The 1031 exchange is intended to be a planned and executed exchange of one property for another. However it is unlikely that the person who wants to buy your property owns a property you want to own. In order to keep your "exchange" classified as a 1031 exchange you must NOT have direct control of the proceeds from the sale of your property. The proceeds from the sale must be held by a qualified intermediary, who holds the proceeds then uses it to buy your replacement property for you. This three-party exchange is treated as a planned exchange of income/business property for different income/business property and can qualify as a 1031 exchange if all requirements are met.

1031 Exchange Timelines

There are two key rules setting time limits that must absolutely be met.

45-Day Rule

At the moment the sale of your property closes escrow, a 45 day time limit begins. It is important that your intermediary receives the proceeds at the close of escrow. Again, if you receive the cash (or check), you can not qualify for a 1031 exchange. You have 45 days to specify to your intermediary, in writing, the property you want to buy.

The IRS actually allows you to designate three properties but you must close on the purchase of at least one of them. Only the identified properties can be used for the 1031 exchange.

There are rules which allow you to designate more than three if valuation rules are followed.

180-Day Rule

At the moment your sale closes escrow, a 180 day time limit begins. You must close on the purchase of your new property within 180 days. If it takes you 45 days to identify you new property, you will have 135 days remaining to close escrow on it. If the 180 days extends past when you normally file your income tax returns you will need to file a tax extension as the 180 day time period will end early if you file your taxes before the end of the 180 day period.

Reverse 1031 Exchange

It is possible to buy the new property before selling the old one and still qualify for a 1031 exchange. When you buy the new property, the title must be assigned to an exchange accomodater. You must identify in writing the property you are selling to accomplish the 1031 exchange within 45 days of the close of escrow of your purchase. Similarly you must close escrow on the sale of your property within 180 days of the close of escrow of your purchase.

Depreciable Property

Special rules apply when depreciable property is exchanged. If you exchange improved land with a building for unimproved land without a building, the IRS will assess a depreciation recapture even if you have not claimed any depreciation for your property. The IRS requires that you recapture all ALLOWABLE depreciation.

Form 3115 - Application for Change in Accounting Method will probably have to be filed if you did not take depreciation. You may be able to use it to claim all or your allowable depreciation. You will likely need the assistance of a professional tax preparer to correctly fill out the form.

1031 Exchange Boot - Cash and Debt

A key concept with 1031 exchanges is that the deferral of capital gain taxes is solely for re-investment. This may lead you to overlook issues which could result in taxes being owed.

Cash Boot: If after buying your replacement property, the intermediary still has cash left over, he will pay it back to you at the end of the 180 day time period. This cash is referred to as boot. It has not been re-invested in income/business property. It will generally be treated as sales proceeds and taxed as a capital gain. If you quickly do a cash-out re-finance on the new property, the IRS could challenge all or part of your 1031 exchange.

Mortgage Boot: If the property you sell had mortgage loans or other debt but the replacement property has less debt, the decrease in debt can be taxed as income to you, just as cash boot is.

1031 Exchange For Vacation or Second Houses

In 2004, Congress tightened rules on using 1031s when selling vacation homes. If you offer a vacation home for rent but do not actually have tenents, a claim for a 1031 exchange would be disqualified. However if you stop personally using the vacation house, rent it out for perhaps a year, exchange it for an investment or business property and solely use the new property in a businesslike way, then a 1031 exchange is possible. Renting out your property for two years is considered to be a safe period but one year plus 1 day has also been acceptable.

Moving Into A 1031 Exchange Residence

If you want to use your new exchange property as either a primary or second home, you can NOT move in right away without causing your 1031 exchange to be disallowed.

In 2008, the IRS set up a safe harbor rule, saying it would not challenge that a replacement dwelling qualified as an investment property if:

1. You rent the dwelling unit to another person at a fair rental price for 14 days or more.
2. Your personal use of the dwelling unit does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling is rented at a fair rental price. (Example: you rent it out for 332 days and use it for personal use for 33 days.)

Ownership Of Property Owned Prior To Exchange

You must own the property for at least two years before selling to avoid its status as investment property being challenged.

Changing Ownership Of 1031 Exchange Replacement Property

If you transfer ownership of 1031 exchange replacement property "quickly", the Internal Revenue Service may not recognize it as property obtained for investment purposes. Flipping houses is not considered to be holding property for 1031 qualified investment/business purposes. Keeping the property for two years for rental income purposes typically qualifies it for a 1031 exchange.

Using A 1031 Exchange For Estate Planning

1031 Exchanges allow an investment to be re-invested and to defer the taxes. However if you are dead you do not perform taxable actions. Your heirs inherit the property at its current fair market value and do not inherit an income tax liability even if they immediately sell it at its current fair market value. The deferred tax you potentially owed on capital gains no longer exists. It died with you.

Summary

1031 exchanges have been used for many years as a way to reinvest all of the value of an investment property into a new investment property, deferring any capital gains taxes. Because of the significant impact on taxes paid, rules have been implemented to eliminate using a 1031 exchange for a use other than swapping investment/business property for like-kind investment/business property. It is easy to not recognize that the IRS might interpret your actions as not completely re-investing into like-kind property and disallow all or a portion of the 1031 exchange. A professional tax preparer and a professional exchange accomodater should be used.

Interpreting how the rules will be interpreted has been joked about by professional tax preparers: "Ask 5 different IRS agents about a rule and you will get 7 different answers".

Internal Revenue Service Section 1031

https://www.govinfo.gov/content/pkg/CFR-2011-title26-vol11/pdf/CFR-2011-title26-vol11-part1-subjectgroup-id46.pdf