By Patton VanVeckhoven
The 1031 Exchange derives its name from Internal Revenue Section 1031, which allows sellers to defer taxes on gains of the sale of property by reinvesting into like-kind properties.
Currently, high-income investors are subject to a 20% long-term capital gains tax, and an additional 3.8% net investment income tax to finance the Affordable Care Act. So an investor that purchased property in 2009 for $400K, and sold it today for $700K, could be liable for taxes of more than $70K on the $300K gain. This is where the 1031 Exchange comes to the rescue.
The basic requirements for a 1031 exchange are:
- The property must be held for business or investment use: Rental properties, raw land, and net leased properties all qualify, but fix & flips, primary residences, inventory, stocks and bonds do not. There is no established hold time, but if the exchange is ever audited, the IRS will look to whether the intent of the exchanger was to hold the property for investment purposes, as opposed to flipping it, so the longer the hold time, the better the chance the exchange will be allowed.
- The replacement property must be of a like-kind: Real property may be exchanged for other types of real property, e.g., residential rental property may be exchanged for farmland or an office building, but not for personal property. Tangible personal property, such as a fleet of trucks, may be exchanged for other tangible personal property, such as an airplane.
- The replacement property must be identified within 45 days of closing the relinquished property: The identification must have a specific description and be in writing. Multiple properties may be identified, as long as their aggregate fair market value does not exceed 200% of the sales price of the relinquished property. However, the property purchased must be 95% of the value of the properties identified.
- The replacement property must be of equal or higher value: Any gain will be taxed. The difference in value, known as “boot,” can consist of cash or a reduction in your mortgage, so if you don’t receive equity or cash, but your mortgage liability is reduced, the reduction will be taxed as “boot.”
- The exchange must be completed within 180 days: The replacement property must be closed on within 180 days of the closing of the relinquished property.
- Qualified intermediaries: The IRS provides that the exchanger must use a qualified intermediary (“QI)”, also known as an exchange accommodator, to hold onto the proceeds. If a disqualified party takes possession of title or the proceeds, the exchange will be disallowed.
Prior to selling an investment or business property, you should consult with your tax adviser as to whether a 1031 exchange makes sense. You may be eligible for offsets that leave you with a negligible capital gain. In addition to consulting your tax advisor, you should consult a real estate attorney regarding the conveyances involved with the exchange; our attorneys at The Hay Legal Group PLLC can help.
In summary, the 1031 exchange is a fantastic tax saving tool available to parties looking to convey business or investment property, and the proper professionals should be contacted to ensure that the above rules are strictly complied with.
Remember, it’s not what you make on the sale, it’s what you keep!