Category: Individual and Business Tax Consulting
Considering selling one investment property and buying another?
Timing is everything with the 1031 exchange.
The 1031 exchange can be a powerful tool for U.S. property investors, but it’s important to know the basic requirements and to understand that timing and form are essential to ensure that the structured exchange is successful in accomplishing the desired gain and tax deferral.
What is a 1031 exchange?
Section 1031 of the Internal Revenue Code (IRC) allows a taxpayer who owns property that is used for investment or for “productive use” in trade or business to exchange that property with a like-kind replacement that will be held for the same purpose and to defer paying taxes on any realized gain.
Effective January 1, 2018, only real property is eligible for the like-kind (1031) exchange.
As long as it is held for qualified use (investment, use in trade, or business, including rental activity), examples of like-kind property can include:
Properties can be exchanged anywhere in the United States, so long as they are “like-kind.” Fortunately, most real estate is considered like-kind. For example, an office building could be exchanged for vacant land, or a retail strip center could be exchanged for an apartment building, as long as both properties are held for investment or used in a trade or business.
The benefits of a gain and tax deferral under a 1031 exchange are numerous, including:
Timing is everything.
As mentioned, timing is very important when it comes to successfully completing a 1031 exchange and requires planning and guidance from your tax professional. It’s extremely rare for the exchange to be accomplished simultaneously. Most 1031 exchanges are known as deferred exchanges, where the sale and the purchase of property occur at different time. The taxpayer has 180 days between the sale of the relinquished property and the closing of the replacement property. In addition, the potential replacement property must be identified within 45 days from the sale of the relinquished property.
The transaction must be structured from the beginning as an exchange, rather than as a sale and purchase. To accomplish this, a qualified intermediary (QI) may be required to be involved in the sale of the relinquished property and the acquisition of the replacement property. The investor would sign an exchange agreement and other documentation before the property sells, and the proceeds from the sale must be held by the QI until they are required to purchase the replacement property.
When a new property is identified as a replacement property, the same taxpayer selling the relinquished property must make the purchase. An exception to this requirement would be an entity that is considered disregarded for tax purposes, like a single member LLC or a revocable trust. To defer all tax completely, the purchased property must be equal or greater in value, equity and debt to the relinquished property. If these criteria are not all met, the transaction may still be a valid exchange, but could be partly taxable.
While the tax code doesn’t specify a minimum time frame to hold the investment property to qualify for tax-deferral, the taxpayer must be able to show that he or she intends to hold the property for qualified purposes. If a property is held for only a short period prior to being sold, this could lead the IRS to question the validity of the investor’s intentions and potentially invalidate the exchange.
Can a vacation home qualify?
Typically personal use real estate would not qualify for a 1031 exchange, because it is not considered to be held for a qualifying purpose. However, the IRS has provided a set of rules that, if followed, would allow the taxpayer’s former vacation home to qualify for the exchange.
For a vacation home to qualify for the exchange, the following requirements must be met:
Get started early with a 1031 exchange.
While the 1031 exchange can yield considerable savings for U.S. property investors, the form of the transaction is very important, and planning in advance is paramount. It’s important to engage your tax professional early in the process, so he or she can calculate the potential tax savings and, if appropriate, guide you to meet all of the requirements for proper exchange.
Under President Biden's proposal, the deferral in any one year would be limited to gains of up to $500,000 for single taxpayers and $1 million for married taxpayers.
This proposal currently is just that - a proposal and would be effective after 12.31.21, if adopted as proposed.
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If you have any questions, please contact your Kerkering Barberio representative.