1031 Exchange – Defer Capital Gain Taxes on Investment Property
In a typical real estate transaction, capital gain taxes are due on the gain from the sale of investment real estate. A 1031 Exchange is used by real estate investors to defer capital gain taxes. A 1031 Exchange allows a property to be sold and replaced without the payment of taxes. A 1031 tax exchange is basically the exchanging of "like-kind" properties of equal or greater value without paying taxes.
In real estate, "like-kind" property is property used as a trade or business as described in IRS Section 1231, or property held as investments as described in IRS Section 1221. Some of the investment properties that qualify for an exchange are rental homes, apartments, office buildings, shopping centers, industrial property, motels, land, farms, ranches, etc. “Like-kind” does not mean that you have to exchange a like rentsl property for another like rental property. You are allowed to mix and match. As long as you are completing a structured exchange, the IRS allows you to exchange raw land for a shopping center, a condo rental for an apartment building, etc. You are allowed to exchange real property used for business, trade or investment purposes for any other type of business, trade or investment properties.
Personal residences do not qualify for "like-kind" property, so they cannot be used for an exchange. With your personal residence you can qualify for the $250,000\$500,0000 Capital Gain Tax Exclusion, which is better than a 1031 Exchange. Qualified personal residences are tax-free, not just tax-deferred.
With the 1031 exchange the gain can’t be taxed. Your income taxes are deferred until the day you decide to sell your property and pocket the sales proceeds. You can avoid ever paying income taxes at all by continuing to exchange properties throughout your entire lifetime. With proper estate planning, you can pass your investment properties to your heirs tax-free.
An exchange must be performed by a qualified intermediary. A qualified intermediary does not have to be an accountant, but they must be a neutral party. They keep track of the sales of the property you will relinquish, as well as the replacement property purchase. The intermediary keeps all of the funds from the sale of the relinquished property in an interest bearing joint trust account, until the settlement of the replacement property. The funds must be held by the intermediary in order to remain tax free.
Guidelines for a 1031 Exchange are as follows:
- You have 45 days from the sale of the relinquished property to identify your replacement property, and you have 180 days from the sale of the relinquished property to settle.
- The value of the replacement property must be equal or greater than the value of the relinquished property(s).
- The equity in the replacement property must be equal or greater than the equity in the relinquished property(s).
- The replacement property(s) must have an equal or greater debt than the relinquished property.
- All of the net proceeds from the sale of the relinquished property must be used to purchase the replacement property(s).
- Entities, such as corporations, trusts, partnerships, LLC' etc. may do a 1031 exchange. They must follow this rule: the tax return that holds title to the relinquished property must be the same tax return that takes title to the replacement Property.
You have 45 days to identify your replacement property after you have sold the relinquished property. The investor can identify up to 3 replacement properties. You also need to settle on your replacement property within 180 days of the sale of your relinquished property. If you cannot identify a replacement property within 45 days or settle within 180 days of the sale of the relinquished property, your fund will now be taxable. The IRS has no exceptions to this rule. These timelines cannot be extended.
One of the biggest 1031 exchange rules that must be followed is that the property being sold has to be equal to or lesser than in value than the new property being obtained. This means if you have an investment property worth $200,000, you can only do a 1031 tax exchange on another property that is worth $200,000 or more. There are absolutely no exemptions from this 1031 exchange rule.
One of the disadvantages to an exchange is that you will have a slightly lower depreciation schedule when you acquire your new properties. Your new property will have the same tax basis as the previous property, which will reduce your yearly depreciation of your new higher valued property.
Although it is not suggested, a replacement property can be converted to a primary residence, as long as you follow the holding requirements of Section 1031. The big concern with the IRS is whether you can prove that you had the intent to hold the property for rental, investment or business use. If your home qualifies for a personal residence, you can take advantage of the home owner's exemption (up to $250,000 or $500,000 for a couple). There is a five year holding period requirement for the personal residence tax exclusion.
An owner that is planning on doing a 1031 exchange should only do so after seeking help from a qualified intermediary, accountant, and attorney.
John and Mary sell their relinquished property for $200,000. After paying the mortgage on the relinquished property, the balance of $80,000 is transferred to the intermediary. If they buy their New Property for $180,000, they bought down by $20,000. The buy down does not kill their exchange, but the $20,000 difference between the exchanging properties is taxable. The IRS calls this taxable amount boot.
10 years ago, Bob purchases an apartment building for $600,000. The IRS allows the depreciation of a property over 27.5 years, which allows for a depreciation of $21,818 per year. After 10 years, the property has depreciated by $218,810. Bob has also made $100K in property and land improvements.
His taxable basis is as follows:
|Improvements over 10 years:||$100,000|
If Bob sells his property for $1 million dollars his federal tax will be as follows:
|Taxable Basis (calculated above)||$481,190|
|Taxable Capital Gain:||$518,810|
|Capital Gain from Depreciation Recapture:($218,810 X 25%)||$54,702|
|Long-term Capital Gain ($300,00 X 20%)||$60,000|
|Total Federal Tax:||$114,702|
In this case, a 1031 Exchange would defer $114,702 in capital gain taxes.
IRS Helpful Links: IRS Tip - Like-Kind Exchanges - Real Estate Tax Tips
Pat Egan is the Broker and Owner of Egan Real Estate in Ardmore, Pennsylvania. Pat sells Main Line Real Estate. Pat has been investing in real estate since 1993. He grew up in construction, and has a good basic understanding of what is needed to make a property work as an investment. Pat has a degree in Electrical Engineering, which he practiced for 6 years. Pat has been helping people buy and sell real estate since 2003. His engineering background helps when analyzing properties for his clients. Please feel free to contact Pat with any questions you may have about real estate at .
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