If you work in commercial real estate, you may know about a 1031 exchange, but if you are new to the industry or looking at investment opportunities, this concept may be unfamiliar. It refers to IRC Section 1031, a tax provision that allows investors who sell businesses or property to avoid paying the taxes on their capital gains at the time of the sale. Under the 1031, an investor who sells a property and reinvests the profits in another similar property, can defer taxes on the gain. You are not escaping taxes, you are deferring them.
Why would deferring taxes offer any advantage? The 1031 places no limits on how often you can exchange one piece of commercial real estate for another. As you continue to sell and reinvest, your investment grows with the taxes deferred. You will not have to pay taxes until you sell your property for cash. Then, you pay one assessment on your profit, rather than paying taxes on your gains over and over.
What is like-kind property?
A 1031 requires the exchange take place between “like and kind” properties. This does not mean you have to sell your laundromat and buy another laundromat and everyone must be nice. “Like and kind” means both properties, the one you sell and the one you plan to buy, must be used in a trade, business or for investment. Your house or your vacation home do not qualify under the 1031 (there is an exception, that we’ll get to a bit later.) In terms of real estate, the IRS considers most real estate as like-kind to other real estate. One exception is investments outside the United States. Property in the U.S. does not qualify as like-kind to land on foreign soil.
Some other exclusions include:
- Improvements to a property.
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
Let’s go back to vacation homes. To get a vacation home qualified under the 1031 exchange, you have to rent it out. This converts the property from a residential to a business property. Experts say not to rush this and plan on renting it to a tenant, six months to a year, with a year being optimal. The more time that elapses, the better, as far as making the like-kind cut.
The idea with a 1031 exchange is obviously to improve your investment, but this requires some special considerations. If you swap improved land that has a building, for unimproved land with no building, you may be looking at paying taxes. The IRS considers any depreciation of the building you claimed on your taxes, recaptured income, meaning you will pay taxes on it.
These boots are made for paying (taxes)
Any cash left over in a 1031 exchange, is considered boot. This is why it’s important to take a good look at any loans connected to the properties you are considering buying. If the liability on the property you are selling is higher than any debt on the property you are buying, you will have to pay taxes on the difference. For example, if you owe a hundred-thousand dollars on your property and swap it for land that has a debt of only fifty-thousand, that fifty-thousand dollar difference is considered boot and its taxable.
Keep an eye on the time
The 1031 like-kind exchange does not have to happen simultaneously, but you do have to meet a couple of deadlines to avoid taxable gain. The only way the IRS ever relaxes these limits is during presidentially declared disasters. Hurricane Katrina and worse is the only way you escape the time limit.
You have 45 days from the date you sell your property, to identify potential replacement properties.The IRS requires the identification be in writing, signed by you and delivered to a person involved in the exchange, such as the seller of the replacement property or the qualified intermediary.Telling your attorney, real estate agent or anyone else acting as your agent, is not enough. Make sure your written description includes a legal description and street address.
Once you have sold your property, you have 180 days to close on the new property. The replacement property received must be substantially the same as the property identified within the 45-day limit described above. In other words, the laundromat described cannot actually be a hole in the ground with an old washing machine dumped in it.
Hands off the cash
It is important to know that while you are waiting for a 1031 exchange of property to take place, you cannot touch the cash. Any proceeds from the sale of your property need to stay in an account until both sales close. Accessing that money, or other proceeds before the exchange is complete, could disqualify the entire transaction from 1031 treatment. At that point all profits become taxed as capital gains.
1031 exchanges make a lot of sense for the real estate investor. It provides a way to keep growing your investment and pay taxes just once. To ensure your deal goes smoothly, use a qualified intermediary and do the proper research on your potential replacement properties. Shortcuts, a lack of research or incompetent intermediaries can prove very expensive.
If you are considering a 1031 exchange, contact our team at Landmark Title Assurance Agency to take you through the escrow process.