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An individual who holds any property for productive use in a trade or business, or for investment, can swap it for like-kind property. Here, "like-kind" pertains to the nature of the investment, not its form. Such an investor can switch one type of investment property for another. For instance, they could trade a single-family residence for a duplex, raw land for a shopping center, or an office space for an apartment complex. Various combinations are permissible, providing the investor with flexibility to adjust their investment strategies based on their objectives.
However, there are limitations. The investor can't exchange shares in partnerships, notes, stocks, bonds, certificates of trust, or other similar instruments. Also off the table for them is trading investment property for a personal residence, property situated in a foreign country, or property defined as "stock in trade." For example, homes constructed by developers and subsequently listed for sale fall under the "stock in trade" category. If an investor purchases properties needing renovation and promptly sells them post-renovation, such properties might fall under the stock in trade designation and would be ineligible for exchange.
Furthermore, if someone frequently engages in exchanges shortly after acquiring properties, or if they trade numerous properties within a short timeframe, they might be categorized as a “dealer”. This designation could render their properties as stock in trade. Those labeled as dealers are typically barred from swapping real estate unless they can unequivocally prove their intent was solely for investment. The criteria to determine a "dealer" status are nebulous. Various factors, including the reasons for acquiring and using the real estate, the duration of ownership, and the primary profession of the owner, might come into play.
Once it's ascertained that the property being offloaded qualifies for a 1031 Exchange, the immediate question is the nature of the new acquisition. As referenced before, section 1031 covers both “real property” and “personal property.” The salient difference between exchanging personal property and real property rests in the interpretation of like-kind
1031 Exchange Timelines and Rules
The 1031 exchange is not a simple sell-and-buy transaction; there are strict timelines and rules which must be adhered to:
a. 45 Day Rule: After selling the relinquished property, the investor has 45 days to identify potential replacement properties. After the sale of the property, the intermediary will receive the cash, not the Relinquished Property Owner, otherwise it would void the rule of 1031. One can identify more than one property according to IRS if they pass certain valuation tests.
Within the 45 days period, it is mandatory to inform the intermediary in writing about the designated replacement property in writing.
b. 180 Day Rule: From the sale date of the initial property, an investor has 180 days to close on the purchase of the replacement property (or properties). This timeline includes the 45 days of the identification period.
Special Note: The two timeframes overlap, meaning that an individual begins the countdown as soon as the sale of their property finalizes. For instance, should they pinpoint a subsequent property 45 days post-sale, a mere 135 days remain for them to finalize that acquisition.
Reverse Exchange
While the typical 1031 exchange involves selling a property and then buying another, there's a variant called the reverse exchange. Here, an investor acquires the replacement property before selling the current property. Due to its complexity, a reverse exchange often requires experienced professionals to ensure compliance.
Special Exceptions for Depreciating Property
Depreciation recapture is a tax provision that requires the taxpayer to pay tax on gains that result from the depreciation of a property. While 1031 exchanges defer capital gains tax, they don’t escape depreciation recapture. If you’ve taken depreciation deductions, be prepared to handle this recapture when you sell, even if you're engaging in a 1031 exchange.
Changes to 1031 Rules
With the Tax Cuts and Jobs Act of 2017, 1031 exchanges are now solely applicable to real estate. Prior to this, it was possible to use 1031 for various types of personal property like artwork or equipment.
1031 Tax Implications
While the main advantage of a 1031 exchange is to defer taxes, it's not a complete tax escape. The deferred tax will eventually be due when the new property is sold, unless another 1031 exchange is executed or other tax planning methods are employed.
1031 for Vacation Homes
Vacation or second homes primarily used for personal reasons don't qualify for tax deferred exchange under IRC §1031. The Tax Court's ruling in Moore v. Commissioner stated that just hoping for a gain doesn't show investment intent for homes solely enjoyed personally.
Revenue Procedure 2008-16 offers guidelines to determine if a dwelling (defined as a unit with basic living amenities) is considered for business or investment use.
For a vacation home to be eligible as Relinquished Property in a §1031 exchange, the Exchanger should:
For eligibility as Replacement Property, the same rules apply but ownership starts after the exchange.
"Personal use" includes non-rent-paying use by friends or family. However, renting to a related party at market rate for their primary residence isn't deemed "personal use". This is confirmed in Adams v. C.I.R.
Moving into a 1031 Swapped Residence
Transforming a 1031 property into a primary residence is a tactic some investors use. However, to obtain the full primary residence exclusion, one needs to own the property for at least 5 years and live in it for at least 2 of those 5 years.
1031 Estate Planning
When integrated into estate planning, a 1031 can be a boon. If held until death, the property gets a step-up in basis, which can significantly reduce or even eliminate the deferred capital gains tax.
How to Report a 1031 to the IRS
For a 1031 exchange, IRS Form 8824 (Like-Kind Exchanges) must be completed. It requires details about the properties and the exchange process. Consultation with a tax professional is advised to ensure accurate and compliant reporting.
In Conclusion
The 1031 exchange is a potent tool for investors looking to optimize their real estate investments. However, its complexities require careful planning, adherence to rules, and often, guidance from professionals. We at Tyler Rose are here to provide you just the right consultation to guide you step-by-step through this process. With the right approach, the benefits of a 1031 exchange can significantly elevate your real estate portfolio’s potential.
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