Under Section 1031 of the Internal Revenue Code, investors may defer capital gains tax realized on the sale or exchange of property if the property is held for business or investment purposes and is like kind. Strictly speaking, Section 1031 is not reserved for real estate; however, it is most frequently used in the transfer of one real estate property for another. To better understand a 1031, there are a few things of which to be aware.
Proper Intent
Section 1031 Can Only Be Used for Business or Investment Purposes. Property held primarily for personal use is excluded from 1031 consideration. Qualifying vacation homes for the capital gains tax exemption can be done but only if certain conditions are met or exceeded. For example, in order to qualify a vacation home as an investment property for the IRS Revenue Procedure 2008-16 safe harbor, the home must be rented for at least 14 days at fair market rent and the taxpayer must not personally use for greater than 14 days or 10% of the total number of rented days for each of at least two years. Occasionally, investors will hope to eventually settle into an investment property as the primary residence. Should an individual hope to do this, the suggestion is to wait for at least two years to satisfy the safe harbor prior to converting the property to personal use, during which time the property is to be used as an investment and rented.
Like Kind
The Definition of Like Kind is Broad. The IRS does not limit like kind property to commonly held standards. For example, the owner of an apartment complex can exchange for other types of real property besides another apartment complex, including undeveloped land, a shopping complex or industrial warehouse. Each property holds the potential to realize deferrals on the capital gains tax. Depending on the type of exchange an investor hopes to achieve, it’s best to contact your CPA or Qualified Intermediary prior to finalizing any sales. Personal property, such as construction equipment, business aircraft, furniture, vintage cars, artwork, gold and silver bullion, numismatic coins and livestock, are eligible for 1031 consideration.
Identification Requirement
An Investor Must Designate a Replacement Property. Finding a replacement property may not be as easy as one would hope. As such, the IRS gives the investor up to 45 days after the closing of his property to designate a replacement property. Up to three different replacement properties, regardless of value or four or more given the aggregate net purchase price does not exceed two hundred percent of the relinquished or old property sold may be designated; however, the investor must close on the replacement property within 180 calendar days post-closing to qualify for the 1031 exchange, otherwise the taxpayer will owe the capital gains and recaptured depreciation tax on the sale.
Equity Boot
If Any Cash Is Left Over, It’s Subject to the Capital Gains Tax. Occasionally, cash proceeds will be left over from the purchase of the new investment property. In those cases, that extra cash, or boot, is subject to capital gains tax.
Participating in a 1031 is an excellent way for investors to take advantage of IRS regulations to defer hundreds of thousands of dollars on capital gains tax. Specific rules apply and must be met; otherwise the investor could find an unfortunate surprise.
The suggested first step when considering selling real or personal property held in a business or for investment is to contact your CPA to determine the capital gains tax. The capital gains tax can amount to 40 percent of more of the asset sales price from federal, state and possibly city capital gains taxes.
Learn more by clicking on the button below for the complimentary “Ten Reasons Why a 1031 Exchange Makes Sense.”
