Owning real estate has long been an attractive means to accumulate wealth on a tax efficient basis. From the mortgage interest deduction to the exclusion of up to $500,000 in gains on the sale of a married couple’s primary home, real estate is the gift that keeps on giving when it comes time to file your taxes. In this article we will be exploring a common tax deferral mechanism available to real estate investors.
The $500,000 capital gain exclusion referenced above is a pretty nice deal, but it is only applicable on the sale of a primary home. Real estate investors are not completely left out of the party though. To defer capital gains on the sale of investment property, real estate investors commonly use what is known as a “1031 exchange”. A 1031 exchange gets its name from Section 1031 of the United Stated Internal Revenue Code, which governs the tax treatment of “like-kind exchanges”.
Long story short, if you satisfy the criteria of the exchange, some or all of the capital gains associated with the sale of your investment property can be delayed until the sale of the like-kind replacement property. This is a very attractive proposition, particularly if you have no plans to sell the replacement property during your lifetime. When the property ultimately passes to your heirs, they would receive a step-up to fair market value.
Before we go any further, it should be noted that Section 1031 exchanges are complicated and should only be undertaken with the help and guidance of an experienced professional. A failed exchange could result in meaningful personal and financial costs.
What qualifies as “Like-kind” property under Section 1031?
Like-kind property is real property used for business or held for investment. Personal, intangible and real property held primarily for sale do not qualify under Section 1031. Like-kind means that the property is of the same nature and character, but not necessarily the same grade or quality. Foreign property is NOT like-kind with domestic property. Finally, a single property could be exchanged for multiple like-kind properties, or vice versa.
In layman’s terms, you can exchange a 40-year-old single family home for two newly constructed condos, as long as the properties are held as investments and located in the United States.
Delayed Exchange and Timeline Limitations
Because it is difficult to arrange an instantaneous purchase and sale of multiple properties, most 1031 exchanges are delayed exchanges. In a delayed exchange, the proceeds from the sale of your property are held by a “qualified intermediary” until they are used to purchase the replacement property. There are limitations on who can serve as a qualified intermediary, in order to exclude related parties or those with an interest in the transaction.
Once the proceeds from the sale of the exchange property are received, you will have 45 days to produce a list of potential exchange properties to the qualified intermediary in writing. You then have up to 180 days from the sale of the relinquished property to complete the 1031 exchange.
Generally, you can identify up to three replacement properties for the exchange. That being said, there are two exceptions to this rule. The first is the 200% rule, which states that you can identify any number of replacement properties, as long as the aggregate value is less than 200% of the gross sales price of the relinquished property. The second is the 95% identification exception, which allows you to identify any number of replacement properties, but requires you to actually close on at least 95% of the value of the identified like-kind properties.
What is boot?
Cash, personal property or other non-like-kind property received in a 1031 exchange is considered to be “boot”. Any reduction in the balance of the mortgage or assumption of debt by the other party would also be considered boot. The receipt of boot will result in the recognition of gain up to the lessor of the amount of boot received or the realized gain.
Safe Harbor Provision for Investment Property
The IRS will not challenge whether the property is held for productive use in trade or business if the following safe harbor conditions are met:
- The relinquished property has been owned by the taxpayer for at least 24 months prior to the exchange.
- In each of the two 12-month periods that make up the 24 months prior to the exchange, the taxpayer rents the property to another person at a fair market rate for at least 14 days and personal use of the property is less than the greater of 14 days or 10% of the days that the property was rented.
A similar safe harbor provision applies to the property received, except the period is the 24 months immediately following the exchange.
Finally, if you plan on moving into the property at some point after two years, the primary residence exclusion cannot be utilized until five years has passed since the exchange has taken place.
In summary, section 1031 exchanges are very complex and require the help and guidance of an experienced professional, but those who are willing to put in the time and effort will be handsomely rewarded with a very attractive means to deferring capital gains on the sale of their investment properties. If you would like to discuss whether a Section 1031 exchange is right for you, please contact us.