Are you thinking about selling a business or investment property that could result in a substantial profit, and consequently, a large tax bill? You may be able to take advantage of a popular tax break that allows you to defer payment of any capital gains taxes due on the sale or maybe entirely avoid them.
Like-kind exchanges, also known as 1031 exchanges for the section of the Internal Revenue Code they fall under, permit taxpayers to replace real estate property used for business or investment purposes with like-kind property without paying taxes on the proceeds.
While this planning strategy is a prudent way to diversify real property holdings and postpone taxes, real estate investors find that 1031 exchanges are complex and have strict requirements. If you are curious about doing a 1031 exchange, here are four considerations about the rules.
1. QUALIFYING PROPERTIES: A key rule about 1031 exchanges is that the transaction must take the form of an “exchange” with “like-kind” properties, rather than just a sale or one property with a subsequent purchase of another. You do not need to trade an identical property type for another. The sold property and the new replacement property must be held for investment purposes or for productive use in a trade or business. Both properties must be within the U.S. to qualify for a 1031 exchange.
The following real estate swaps are examples of those that are comparable, fitting the qualified exchange of “like-kind” property rules:
- Apartment building for industrial building
- Office for shopping center
- Raw land or ranch for a strip mall
- Shopping center for raw land
Notably, properties for personal use, like your primary residence or vacation house, usually do not qualify for 1031 treatment. Also, land that is under development for resale is not eligible for 1031 exchanges. Securities and financial instruments, such as stocks, bonds, notes, and partnership interests, typically do not qualify as forms of like-kind property for exchange purposes.
Planning Insight: Should you use a 1031 like-kind exchange, you will need to complete IRS Form 8824 and attach it to your yearly tax return. Be mindful that there are certain conditions that can enable you to utilize a 1031 exchange on a principal or vacation home. You would need to rent the property out for a certain amount of time and limit how long you stay there. Refer to this IRS site for details.
2. SPECIFIC TIMELINES AND RULES Keep an eye on the calendar to successfully complete a 1031 exchange. Finding and closing on replacement property within strict time limits can be challenging in today’s market, where inventory is near historic lows in many areas.
First, you need to identify one or more replacement properties within a narrow window of 45 days of the date of the sale. This replacement property must be of equal or greater value than the original. You can buy as many as three properties without regard to the fair market value, or any number of properties, as long as their aggregate value does not surpass 200% of your original property’s sale price.
Planning Insight: To avoid challenges complying with the required time periods, you should think about naming a Delaware Statutory Trust (DST), which is a separate legal entity, as one of the replacement properties. Similar to a real estate investment trust, a DST can serve as a professionally managed back-up in the event you struggle to find a single replacement property that meets all of the Section 1031 exchange requirements within the 45-day identification period. Each DST 1031 investor has a fractionalized ownership interest in the Trust, which in turn owns the property. The IRS treats the security owned by the DST investor as direct property ownership, consequently qualifying for a 1031 exchange. Real estate owners who seek the tax deferral benefits of 1031 exchanges and wish to avoid day-to-day management responsibilities often appreciate the advantages of DST co-ownership. Subject properties, such as institutional-grade multifamily apartments, distribution facilities, medical buildings, and national brand hotels, are usually over $100 million and far out of reach for smaller “do it all yourself” individual investors.
3. USE A QUALIFIED INTERMEDIARY: To facilitate a 1031 exchange, you should always choose a qualified intermediary, such as a third-party real estate lawyer, accountant, or title company, to hold the funds in escrow for you. If you take receipt of the funds before the exchange is complete, you could ultimately trigger a massive tax bill, which will eliminate the tax-deferral benefit.
This qualified intermediary, as specialized custodian, will hold the proceeds from the relinquished property and use them to acquire the replacement property, preventing the taxpayer from coming into contact with them. You can find a state-specific qualified intermediary through the Federation of Exchange Accommodators (FEA), which is the only national trade association organized to represent professionals who conduct section 1031 like-kind exchanges.
Planning Insight: Be mindful there are certain conditions that can enable you to use a 1031 exchange on a principal or vacation home. You would need to rent the property out for a certain amount of time and limit how long you stay there. Refer to this IRS site for details.
4. WEALTH PLANNING BENEFITS: A 1031 exchange can be an advantageous estate planning tool. If you complete successive 1031 exchanges without paying capital gains taxes and then pass away, you may avoid taxes altogether, since your beneficiaries will inherit the property with a stepped-up basis equal to the value of the property at the time of death. Be aware that these current tax code rules may be subject to change in the future.
Another benefit of a 1031 exchange is that you may avert taxes associated with depreciation. If you swap one depreciable building for another building, you can avoid depreciation recapture, which is a profit taxed over time as ordinary income.
The upshot is that a 1031 exchange is an efficient, but complicated, technique to delay taxes on investment properties. Seek the guidance of a qualified tax professional, real estate attorney, or 1031 exchange agency, in tandem with a CERTIFIED FINANCIAL PLANNER™ professional, to support you throughout this complicated process.