Real estate investors should be familiar with the requirements of the Internal Revenue Code Section 1031 exchange. All too often, taxpayers have mis-interpreted or received bad information that can potentially jeopardize the tax consequence of their real estate investment. A 1031 exchange allows the taxpayer subject to federal and state taxes to defer the federal and state capital gain along with the depreciation recapture taxes when selling and replacing with like-kind property. The deferral represents an indefinite interest free loan that is not due until the replacement property is sold. Imagine an interest free loan that can represent up to forty percent of the sales price.
Like Kind
Like kind real or personal property exchanges allow the taxpayer to replace with any type of real or personal property given the relinquished or old property is located in the US and replaced with real or personal property located in the US. Taxpayers subject to federal tax can also exchange internationally held property for any real or personal property held outside the US, implying a Taiwanese real estate investment can be exchanged for real property held in India. Real property is only like kind with real property while personal property such as aircraft, gold and silver bullion, collectibles and equipment, must be exchanged for the same class or group of personal property.
Proper Intent and Personal Use
Real estate investment must be productively held in a business or for investment and replaced with real property productively held in a business or for investment, implying that personal use must be held to a minimum of either fourteen overnights or ten percent of the rental nights per year. Facts supporting a potential an exchange include limited personal use, keeping the property in an active rental pool and itemizing the asset on Schedule E of the taxpayer’s federal return reflecting revenues, expenses and depreciation. Rentals to family members count towards the personal use threshold unless the family or related party is utilizing the home as their primary residence and paying fair market rent.
The real property can always be converted to a primary residence but should first be held as an investment property for at least two years. Once converted and later sold as a principal residence, the Section 121 exclusion can exclude up to $250,000 per taxpayer or $500,000 if married and filing jointly.
Same Taxpayer Requirement
The taxpayer selling is the taxpayer who must acquire the replacement property. If a wife is on title to the relinquished property, then the wife should be the titleholder on the replacement property. The husband can be added to the replacement property title once the 1031 exchange is old and cold. If a two or multi member limited liability company is on title and the members want to go their separate ways upon the sale, a drop and swap strategy can be implemented as far in advance of the placing the property on the market as possible. The drop and swap strategy is where the limited liability company is dissolved and drops the title to the names of the individuals as tenants in common. The purchase and sale agreement is entered into by the individuals allowing them to go their separate ways at escrow or closing. Your CPA’s input is suggested prior to initiating the drop and swap given the Internal Revenue Service collects the titleholder drop information on form 1065, questions 13 and 14 in section B.
Exchange Value
The like kind exchange premise is that the taxpayer’s economic position does not change from the sale to the subsequent replacement property purchase. Given the replacement net purchase price is equal to or greater than the relinquished net sales price then the gain is deferred. If not all the net equity or debt retired is replaced in the replacement property, a tax is triggered on the balance, known as equity and mortgage boot.
There are many rules to follow when considering a tax deferred exchange such as selling or acquiring property from a related party and all “safe harbor” exchanges must be completed within 180 calendar days. Engaging a qualified intermediary is required for three and four party exchanges, but not required when both the seller and buyer want each other’s property in a two party exchange.
When you are contemplating a 1031 exchange, call our office or click on the button below to speak with a Certified Exchange Specialist® to ask questions or for a quote.
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