Selling properties (land or buildings) for a profit will result in gains from each sale will be subject to a capital gains tax. If held of over a year the capital gain will be taxed at a more favorable long-term rate but if held less than a year would be taxed at ordinary rate. Super important to remember you would have to pay back depreciation taken through the years once the property is sold. However, you can defer paying those taxes by using the proceeds of your sale to buy a replacement property in a 1031 property exchange.
A 1031 property exchange can be an effective tax-saving tool that enables a business to delay, not eliminate, taxes it would otherwise owe for the year it sold the property. To be eligible for the tax deferment, the transactions must comply with specific rules and timelines established by the IRS. This guide will cover the details of how to conduct a 1031 property exchange, as well as key items to be aware of.
1031 Property Exchanges Rule States
A 1031 property exchange is a type of “like-kind” exchange that’s permitted under Section 1031 of the U.S. tax code. The law allows businesses to sell real property and postpone tax payment as long as the proceeds is invested in another similar property. This is beneficial as it allows you to reinvest in another property by delaying your taxes.
One of the most common types of 1031 exchanges involves a simultaneous swap of one property for another similar property. However, buying and selling properties at the exact same time isn’t always possible, so the IRS permits deferred swaps in which you can sell a property and buy another one and take 1031 as long as it stays in the time period.
A deferred property swap must be coordinated by a qualified intermediary (also called an exchange facilitator). You must designate an intermediary before you close on the sale of the property you’re relinquishing. Your intermediary will hold the proceeds of the sale and use the money to purchase a property exchange.
Property Requirements for a 1031 Exchange
In order to qualify for a 1031 exchange, both properties must be used in a trade or business or for investment. They must also be like-kind which the IRS has a very broad interpretation of that term. Properties are generally considered like in kind if they’re similar in nature, character, or class (e.g., they’re both real estate). However, the properties don’t have to be exactly of the same quality or even used for the same purpose. For example, you can exchange a retail shopping complex for an apartment.
Keynote, the property you own for personal use, such as your primary residence or second home, doesn’t qualify for a 1031 exchange. However, don’t forget each taxpayer has a $250,000 gain home exemption once sold so a married couple has $500,000 gain exclusion which is very helpful.
1031 Exchange in Action
Let’s set up a scenario, so you’ve decided to sell a shopping plaza and you wise to do a deferred property swap. A wise first step would to choose a qualified intermediary, for more context someone who has experience handling 1031 property exchange and is not disqualified by IRS rules.
Your intermediary should not be the person who served as your agent at the time of the property closed so it would need to be another professional. IRS rules also exclude anyone who acted as your employee, attorney, accountant, investment banker, broker, or real estate agent within two years of the transfer of the relinquished property.
To qualify for a 1031 exchange, you must follow these important timelines:
- You must provide your intermediary with a description of your replacement property within 45 days of the sale of the relinquished property. (So, this means the property must be identified)
- You must close on the purchase of the replacement property within 180 days of the date of the initial sale or of the income tax due date for the year in which it occurred, whichever is earlier.
Can you live in a 1031 Exchange Property?
It’s not possible to declare your property as primary residence immediately after an exchange. There are some requirements that must be fulfilled before you opt for this move. These requirements include:
- You must own the property for at least 2 years after the exchange
- Out of these 2 years, in a 12 months period, you must rent the property for at least 2 weeks to someone else.
- During the year you rented the property, you should not use the property for personal reasons for more than 2 weeks
Using 1031 Exchange for Primary Residence
Mostly, It’s not possible to make 1031 Exchange for your Primary residence as it is solely reserved for Business and Investment purposes. However, you can use section 121 to convert your primary residence to 1021 property and then you can use 1031 exchange for business purposes.
Depreciation Recapture Don’t Forget
When the property is sold for a profit don’t forget about the depreciation taken throughout the years which has accumulated on the property. This is depreciation is considered “recaptured” and will be treated as a gain. Recaptured depreciation is taxed as ordinary income, not long-term capital gains which could be much more painful if you are in the higher tax bracket. Depreciation will be recaptured if one or both properties aren’t depreciable. Note land is not depreciated as an asset so it will not be recaptured.
A 1031 property exchange could help you avoid depreciation recapture in some cases, but it’s complicated—which is why it is wise seek professional help.
A 1031 Exchange Example
Here’s an example of how a 1031 exchange works.
Let’s say Henry bought a shopping complex 10 years ago for $900,000. He has claimed $250,000 in accumulated depreciation. Bob’s adjusted basis is $650,000 ($900,000 – $250,000). When Henry sells that shopping complex for $1,000,000, he realizes a taxable gain of $100,000. 45 days later he identifies and within 6 months, Henry buys and closes an apartment building for $1 million. He invests the full proceeds of $1,000,000 he received from selling his shopping complex.
Because Henry has exchanged the shopping complex for an apartment building, he can defer the taxes he’d otherwise owe on his $100,000 capital gain. He can also defer the tax on the $250,000 in depreciation recapture. This is could prove to be very beneficial as this could help his cash flow to close other deals or even sit on this new property until he passes it down to his kids. That is an article for another day, the kids would get a step-up basis after he passes away and the property exchange goes to them which negates the deferred taxes.
Changing Ownership of Replacement Property after a 1031 Exchange
If you wanna change the ownership of the property after making a 1031 exchange, you’ll be liable to pay taxes on your gains if the value of the property increases over time.
Conclusion
A 1031 property exchange can be an effective tax-saving tool if your business buys and sells real property as you can defer capital gains until you sell the replacement property without making another exchange. You’ll qualify for a tax deferral only if you meet the timelines and other requirements outlined in Section 1031 of the U.S. tax code so be sure these guidelines are met.
