There are many compelling reasons to consider utilizing a 1031 exchange. The following most frequently asked questions we’ve received over the last sixteen years should serve as a starting point and resource to understand the basics and vocabulary of a 1031 exchange. Should you not find the answer you’re looking for, we take great pride in being a resource and supporting individuals as they learn more about 1031 exchanges and look forward to hearing from you.
Is tangible and intangible personal property eligible for 1031 exchange treatment?
Effective January 1, 2018, the Tax Cuts and Jobs Act of 2017 (TCJA) eliminated tangible and intangible personal property from the Internal Revenue Code Section 1031. Currently, only real property is eligible for the tax deferral. Prior to the TCJA, aircraft, equipment, furniture and fixtures, collectibles, gold and silver bullion, numismatic coins, franchise and licenses, patents were exchanged deferring recaptured depreciation, federal and state capital gain taxes.
Can an investment property be converted into a primary residence?
Yes. A rental property can be converted into a primary residence as long as the Exchangor did not have a concrete intent to convert at the time of purchase. If the property is converted soon after the purchase, the IRS will most likely want to talk with you. If you have an undefined intent to build a home or the possibility of conversion exists, but no definite plans have been established or architectural drawings have been created, then this intent should not prevent the conversion.
Revenue Procedure 2008-16 provides a safe harbor helping us to understand how long a replacement property must be held prior to conversion. The property qualifies as replacement property if held for two years. If the replacement property is a rental, then it must be rented to another person(s) (non family member) at a fair market rental for 14 days or more; and the Exchangor’s use does not exceed the greater of 14 days or 10% of the number of days during the two 12-month periods the property is rented.
What are the tax consequences when the primary residence represents replacement property in a 1031 exchange?
Now that the property is held as a primary residence, it is subject to §121 and is eligible for the $250,000 (if filing single) or $500,000 (if filing jointly) gain exclusion. The property must be held for a five year period beginning when the property was initially purchased as a replacement property. The §121 exclusion does not apply to the years the property was held as a rental property or not as the Exchangor’s principal residence, otherwise known as “non-qualified use.”
Given two years held as an investment property, converted to a primary residence in year three and later sold at the end of the fifth year, the property is sold for a realized gain of $300,000. Two fifths of the gain is non-qualified representing $120,000 for the two years held as an investment property. Three fifths or three years is eligible for the gain exclusion or $180,000. There are multiple variables to consider when determining the tax consequences. See the Housing Assistance Tax Act of 2008 in the 2008 1031 Newsletter and seek the counsel of your accountant.
Do I need to reinvest only the net equity?
If the objective is to defer the entire Federal capital gain and recaptured depreciation, then both the debt retired at the closing and the net equity otherwise known as exchange proceeds must be reinvested. The first dollar received at closing is taxable.
What about the earnest money deposit or funds used to improve the property, can I take that out without having to pay Federal capital gains tax?
The IRS views this as taxable and yes, funds once in an exchange and removed will be taxed twice. You can receive the cash at closing but it will be taxed.
Can I do a partial exchange?
Yes. Whenever considering a partial exchange talk with your accountant to determine whether it is in your interest. There is a point once you get close to removing 50% of the total value (net equity plus debt retired) that it does not make sense to initiate an exchange.
Can the replacement property be purchased from a family member?
Yes, if the family member is also exchanging into another property. If the family member is cashing out, then the answer is no.
Can the relinquished (old) property be sold to a family member?
Yes. But the family member cannot sell the property for two years; otherwise their transaction will trigger the tax you have deferred. The IRS is looking for what is called related party transactions on Form 8824 used to file the 1031 exchange with your yearly Form 1040.
What is a related party?
The term “related party” is any person bearing a relationship to the Exchangor described in Section 267(b) or 707(b)(1) including:
- Family members (siblings, spouse, ancestors, and lineal descendants)
- Individual and corporation, when more than 50% in value of the stock is owned directly or indirectly by or for such individual
- Two corporations part of the same control group
- A grantor and fiduciary of the same trust
- A fiduciary and a beneficiary of the same trust
- A fiduciary of a trust and the fiduciary or beneficiary of another trust where the same person is the grantor of both trusts
- A fiduciary of a trust and a corporation more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for the grantor of the trust
- A person and a Section 501 organization, if the organization is controlled by that person or that person’s family
- A corporation and a partnership is the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of capital interest or profits interest in the partnership
- An S corporation and another S corporation or a C corporation if the same persons own more than 50% of the value of the outstanding stock of each corporation
- A partnership and a person owning, directly or indirectly, more than 50% of the capital interest, or profits interest, in such partnership
- Two partnerships in which the same person own, directly or indirectly, more than 50% capital interests or profits interests
- An estate executor and the beneficiaries of the estate
My property is being purchased by the State under condemnation or eminent domain, does a 1031 apply?
No, a 1031 exchange does not apply. Section 1033 is the relevant Internal Revenue Code (I.R.C.) and provides that the Seller has up to two years to replace the property. The Taxpayer has two choices either use the “similar or related in use” where the replacement property must have the same functional use of the condemned property.
The replacement property can be improvements on land already owned by the Taxpayer. Or use the standard under I.R.C. §1033(g) which is the same as found under I.R.C. §1031, like-kind property for like-kind property. There is no need for an intermediary in a §1033 transaction.
Does the relinquished property need to be held for a certain amount of time?
The general answer is no, however a one year hold time is suggested. The shorter the hold time the more supportive the facts need to be. Exchanges are composed of intent and facts. Hold time is one fact of many that support the intent to defer the taxes in a 1031 exchange.
If the relinquished property is a vacation home or consists of a dwelling unit (bedroom, bathroom and kitchen), Revenue Procedure 2008-16 applies effective for exchanges after March 10, 2008. The investment property must be held for 24 months prior to the sale and in each of the two 12-month periods: (1) the Exchangor rents the relinquished property to another person or persons at fair market rental for 14 days or more; and (2) the Exchangor’s personal use must not exceed the greater of 14 days or 10% of the number of the rentals days for that period. The replacement property if a dwelling unit must adhere to a 24-month hold and usage requirements.
Can I exchange personal property for real property?
No, real property can be exchange for any real property; land for rental or storage units for parking garage. Personal property is no longer eligible for 1031 exchange effective January 1, 2018.
Can foreign property be exchanged for US property?
No, US property must be exchanged for US property while foreign property must be exchanged for any foreign property.
Can a self directed IRA purchase property I own or from a family member?
The general answer is no, you cannot purchase from yourself or ascending or descending family member. The IRS is gray on whether you can purchase from your brother or sister.
I am a developer of residential homes and commercial properties, can I utilize a 1031 exchange?
Yes, if those properties you wish to exchange are held separately from the properties you hold as inventory. Hold the properties either under a different company or at least have the properties accounted for differently as on a separate balance sheet. Inventory is not eligible for 1031 consideration.
Why should I consider a 1031 exchange when selling an investment property?
The tax deferral that can represent upwards of 40% in high state capital gain states like California and allows you to purchase more property, translating into greater appreciation and ultimately greater profits. In addition, there are a number of other reasons unrelated to the Federal or State tax deferral, including:
- Taxpayer is moving to another location, city or state and wants to be close to the property
- The old property is located in an area that is no longer appreciating as fast as another locale
- Greater cash flow can be generated by a rental property versus land
- The old property has been or is close to being fully depreciated. Exchange to benefit from greater depreciation
- Exchangor wants to exchange several smaller investment properties into one or consolidate
- Exchangor wants to diversify from one property into many smaller properties
Is a 1031 exchange really tax free?
Yes, if you die with the property and it is gifted to your heirs. Your beneficiaries receive the property at the stepped up basis not at the price you paid for it. Otherwise, no, a 1031 exchange defers the tax liability indefinitely until the replacement property is sold. There is no limit to the number of 1031 exchanges you can initiate.
Is an assignment considered real property?
It depends upon whether the state views the assignment as real property. Ask your attorney whether an assignment is considered real property. Ask is there a hold time requirement. Some states don’t recognize the assignment as real property until it has been held for a minimum of one year.
Can the Earnest Money Deposit for the replacement property be paid from exchange proceeds?
Yes, the EMD can be paid from the proceeds. All that is needed is the amount and wire instructions.
If the lender requires the spouse on the replacement property loan and not the spouse who owns the relinquished property, how does that impact the exchange?
This is a complex question. If the spouse on the old deed has debt and the other spouse not on the new deed is the required name on the new loan (the new debt replaces the old debt) the spouse on the old deed is receiving a benefit or mortgage boot. The lender is not requiring the loan holder to be on the new deed. The mortgage boot will trigger a tax calling into question whether the exchange will defer adequate gain to be worthwhile.
Inherited real or personal property and are considering selling?
At the time the property is transferred, the beneficiary receives what is known as “stepped up basis.” This means the value is received at the then current value. If sold, there is no capital gain or tax due. If the property is held and at the time of the sale, the property has appreciated over the value when it was received, a capital gain tax is triggered. If the intent is to replace the property, then a 1031 exchange would be of benefit to defer the capital gain tax triggered.
Can a Non Resident Alien purchase US based vacation property?
Absolutely, foreign individuals and corporations can and do purchase vacation property in the US just like US citizens. If the intent is to hold as an investment and later defer the capital gains and recaptured depreciation taxes in a 1031 exchange, personal use may not exceed 14 overnights per year or 10% of days rented. The investment property must also be held for two years prior to selling to qualify. Replacement property must be held for two years per Revenue Procedure 2008-16. When selling avoid the 10% withholding tax by completing the FIRTPA requirements now.
What taxes are triggered on the sale of real estate?
It depends upon the state, how long it has been owned or the holding period and whether depreciation was taken on Schedule E of the federal tax return. The potential taxes are federal and state capital gain and recaptured depreciation. A fourth may be a county option income tax which may be assessed on the entire gain. Many states do not have separate capital gains tax rates rather they asses capital gain as ordinary income subject to state income tax rates. Seven states do not have a state income tax including Florida, Texas, Washington, Nevada, Wyoming, South Dakota and Alaska. Tennessee and New Hampshire tax dividend and interest income.
The federal capital gain rate for real estate held for less than twelve months is taxed as ordinary income ranging from 10% to 35%.
Real estate held for one year and day or greater and total income (including capital gain income) is in the 25% bracket or higher, the capital gain rate is 15%. The exception is if your income tax rate is 10% or 15%, long term gains is 0%.
A 25% recaptured depreciation tax is assessed on depreciation taken over the years.
Taxes imposed can represent 40% of the sale price.
What is capital gain?
Capital gain is the profit or the difference between the purchase and the selling price received when a capital asset is sold. A capital asset is defined as those real, intangible and tangible personal property assets excluding inventory or property held for sale but rather for investment and depreciable as opposed to assets held for personal enjoyment or use.
What is recaptured depreciation?
The Internal Revenue Service generates revenue or collects income taxes on the gain of an asset when sold. The gain is determined in three easy steps:
- Determine the adjusted basis. Adjusted basis is the original purchase price plus the improvements less the total depreciation taken each year on Schedule E of the Taxpayer’s federal 1040 income tax return
- Next, the sales price less the adjusted basis less the selling expenses of sales commissions and closing costs equals the realized capital gain
- Finally, subtract the depreciation from the realized gain and multiply by 25%. The remaining amount is then multiplied by 15% given the property was held for at least one year and a day and the taxpayer’s bracket is 25% or greater. If the hold time is less than one year, add the gain to Taxpayer’s income to determine the income bracket tax rate. This result is known as the recognized gain representing the amount of tax due. This is also the amount of tax dollars deferrable in a 1031 exchange. Given the depreciation allows the Taxpayer to annually deduct a proportion of the asset’s basis reducing the Taxpayer’s income tax due, the IRS charges back or recaptures 25 percent of what was depreciated. With bonus depreciation of 50 percent and more, the recapture depreciation can be a large amount.
What if in a two member limited liability company one member wants to 1031 exchange and the other wants to cash out?
Recently, the IRS added questions 13 and 14 to Form 1065, asking whether in the current or prior tax year, did the entity distribute property to another entity or to any partner in a tenancy in common interest. The days of swap and drop of old when partnerships and multi member limited liability companies dropped ownership to individual members prior to the sale allowing one to 1031 exchange and the other to cash out are now at Exchangor’s risk.
The suggested option is to drop at least one year in advance or post acquisition to avoid the Service’s position that the individuals did not acquire the property for investment purposes.
In a reverse 1031 exchange who is on the purchase contract?
If the EAT is parking the property, then the EAT should be on the contract. The contract is negotiated by the Exchangor and signs under “Read and Approved.”
If the EAT is not parking the property, then the Exchangor should be on the contract making sure to include the assignment language. The contract is assigned at the closing to the Qualified Intermediary as a required step in the 1031 exchange.
