NOTE: This article is meant as an overview of 1031 exchanges, selling a property, deferring “gains taxes” and using the proceeds to purchase another property. This is not to be considered legal advice. An IRS 1031 exchange is complex and may require local and experienced attorneys and accountants.
If you’ve ever heard of a 1031 Exchange (like-kind exchange), you may be wondering what it is and if it could help you reduce capital gains taxes when selling a property. Read on for help navigating this topic.
The Internal Revenue Code 1031 allows a seller to defer capital gains and recaptured depreciation taxes during the sale of real or personal property that has been held for investment, in the production of income, in a business and replacing with real or personal property held for investment, or in the production of income or in a business. The Exchangor/Owner is then able to use the deferred taxes as additional capital towards the purchase of another real or personal property. The gain it represents can be used to purchase a greater value property instead of paying the tax that would be deferred until the sale of the replacement property. This maximizes the marginal use of the taxable dollars.
Short Term Vs Long Term
Reporting on Real Estate Transactions
A short-term gain occurs when you make a profit on the sale of an asset you’ve held for 1 year or less. A long-term gain occurs when you have held the asset for 366 or more days before the close of the sale. What does this mean for you? Capital gains tax is higher on a short-term gain than a long-term gain, so most real estate transactions are held for at least 1 year before selling to avoid this.
Are capital gains taxes paid on the sale of real property, like a home, unimproved property, or commercial buildings?
The sale of a primary residence has many exemptions and special rules, so we will set that consideration aside. Looking at investment properties or business properties, you can often produce a recurring revenue stream. If your mortgage and fixed expenses are covered, you will be able to bring in a profit each month and hopefully receive a bigger payout when you do sell.
When it is time to sell, however, consider that the IRS will then collect capital gains taxes. In 2015 and 2016, the capital gains tax rate was 15% (for those in the 25%, 33%, and 35% tax brackets) and 20% (for those in the 39.6% tax bracket). If you enjoy a nice profit, you may see a big hit when it comes to taxes. For instance, if you gain $100,000 on the sale of the property, you will end up owing $15,000 in taxes! While you still have to pay the taxes, you can lighten the load by considering your options.
An Example Sale
You purchase a property for $50,000 on a $25,000 loan and sell it after 10 years for $150,000. The property is valued at $25,000 when you purchase it and depreciates each year for a total of $9,091. Once you add in selling expenses (including realtor sales commission), title insurance, and other closing costs, it totals $13,500. Your total capital gain from the sale is $95,591.
If you use a 1031 exchange, the tax deferred is $15,248. That includes recaptured depreciation of $2,273 and federal capital gain of $12,975. Now you can reinvest $150,000 or more in a replacement property instead of exiting closing with the after-tax equity, and that $15,248 will continue to work for you. The 1031 exchange essentially works as an interest-free loan. You can use the extra cash to fund new investment opportunities!
1031 Exchange FAQs
Can I offset taxable gains with losses?
If you’re looking for a way to reduce your tax exposure during the sale of your rental property, one way is to pair the gains from the sale with a loss from one of your other investments. This is called tax loss harvest, and it’s often used by people to reduce the amount of money they owe from stock gains at the end of the year. You can also use this strategy with investment and business real estate property because the IRS allows gains to be paired with losses to lower the amount owed. If, for example, you made $50,000 on a rental property sale but lost $75,000 in the stock market, you can offset $50,000 and consider the profit from the rental property a wash.
Can I convert my investment property into a primary residence with the gains from the sale?
An investment property can be converted into a primary residence as long as it was not your express intent to do so when you purchased the property. If you are considering building a home or converting but have no architectural drawings or concrete plans, it shouldn’t be an issue. If you start converting soon after purchase, the IRS will likely want to discuss.
What are the tax consequences when my primary residence represents replacement property in a 1031 exchange?
As a primary residence, the property is subject to 121 and eligible for a $250,000 (filing single) or $500,000 (filing jointly) gain exclusion. You must hold the property for 5 years, starting when you first purchase it as a replacement property. The years the property was used as a rental property or not your primary residence do not count towards the 121 exclusion (non-qualified use). If it’s used for 2 years as an investment property, converted to ap primary residence in the third year, and then sold at the end of the 5th year, the realized gain is $300,000. Two-fifths of this ($120,000) is considered non-qualified because of the 2 years as an investment property. Three-fifths (3 years) is eligible, which amounts to $180,000. There are many things to consider when thinking about your tax consequences in these situations.
What about the net equity? Do I have to reinvest it?
If you are looking to defer the entire federal capital gain and recaptured depreciation, both the debt retired at closing and the net equity (exchange proceeds) must be reinvested. The first dollar you receive at closing is considered taxable.
Can I take out the earnest money deposit or funds used for improvement without paying federal capital gains tax?
No. The IRS considers this taxable. Any funds removed that were once in an exchange will be subject to taxation twice. While you can get the cash at closing, you can’t avoid the tax.
Can I do a partial exchange?
Yes. Once you get close to removing 50% of the total value (the net equity + retired debt), it may not make sense to initiate an exchange. Speak with your licensed accountant to decide if it would benefit you.
Can I purchase replacement property from a family member?
If the family member is exchanging into another property, yes. If they will be cashing out, no.
Can I sell the relinquished property to a family member?
Yes, but that family member must hold onto the property (not sell it) for at least 2 years. If they sell before that time, the transaction will trigger the deferred taxes. The IRS will be looking for “related party transactions” on Form 8824 that is used to file the 1031 exchange with the yearly 1040 form.
What is a related party?
Any person with a relationship to the Exchangor described in Section 267(b) or 707(b)(1) is considered a related party. This includes:
- Family members – siblings, spouses, ancestors, and lineal descendants
- Individual and corporation when more than 50% in value of the stock is indirectly or directly owned by or for individual
- Two corporations part of the same control group
- Grantor or fiduciary of the same trust
- Fiduciary and beneficiary of the same trust
- Fiduciary of a trust and fiduciary or beneficiary of another trust where the same person is the grantor of both trusts
- Fiduciary of a trust and corporation more than 50% in value of the outstanding stock that is owned, directly or indirectly, by or for the trust or by or for the grantor of the trust
- A person and Section 501 organization, if the organization is controlled by that person or the person’s family
- Corporation and partnership if the same person owns more than 50% in value of the outstanding stock of the corporation and more than 50% of capital interest or profits interest in the partnership
- An S corporation and another S corporation or C corporation, if the same persons own more than 50% of the value of the outstanding stock of each corporation
- A partnership and a person owning, directly or indirectly, more than 50% of the capital interest or profits of interest in such partnership
- Two partnerships in which the same person owns, directly or indirectly, more than 50% of capital interests or profits interests
- An estate executor and the beneficiaries of the estate
Does the relinquished property have to be held for a certain period of time?
Generally, no; however, a 1-year hold is suggested. Exchanges are composed of intent and facts. The shorter the hold time, the more supportive the facts have to be. Hold time is just one of the factors considered when supporting the intent to defer taxes in a 1031 exchange.
If the relinquished property is a vacation property, Revenue Procedure 2008-16 applies – effective for any exchanges occurring after March 10, 2008. The investment property must be held for 24 months before the sale in each of the two 12-month periods: (1) the Exchangor rents the relinquished property to another person at fair market rental for 14 or more days; and (2) the Exchangor’s personal use must not exceed the greater of 14 days or 10% of the number of rental days for that period. The replacement property of a dwelling unit must follow the 24-month hold and usage rules.
Can I exchange personal property for real property?
No. Personal property must be exchanged for the same type of personal property, e.g. real for real, land for rental/storage/parking.
Can foreign property be exchanged for U.S. property?
No. U.S. property must be exchanged with U.S. and foreign for foreign.
Can a self-directed IRA purchase property from myself or a family member?
Generally, no. You can’t purchase from yourself or ascending or descending family members. Purchasing from a sibling is a gray area.
Can I use the 1031 exchange if I am a residential and commercial developer?
Yes, if the properties you are considering exchanging are held separately from inventory properties. Inventory is not eligible for a 1031 exchange, so hold the property under a different company or account for it on a separate balance sheet.
When selling my investment property, why would I consider a 1031 exchange?
The tax deferred in an exchange could be up to 40% of the sale since a federal capital gains rate of 15% allows you to purchase more property. This means greater appreciation and profits. Additional reasons for an exchange could be:
- The taxpayer is moving to be close to the property.
- The old property is located in an area that is not appreciating as fast as a new location.
- A rental property can produce greater cash flow than land.
- The old property is now (or close to) full depreciation.
- The Exchangor wants to consolidate by exchanging several small properties.
- The Exchangor wants to diversify.
Is a 1031 exchange really tax free?
Yes and no. If you die and your property is passed to heirs, beneficiaries will receive the property at the stepped-up amount – not at the price you paid. In other instances, the 1031 exchange defers tax liability indefinitely until the replacement property is sold.
Is there a limit on the number of 1031 exchanges I can initiate?
What is recaptured depreciation?
The IRS collects income taxes and generates revenue on the gains of assets when they are sold. Gain is determined in 3 ways:
- Original Purchase Price (+) Improvements (-) Total Depreciation Each Year (on schedule E of taxpayer’s 1040 income tax return) = Adjusted Basis
- Sales Prices (-) Adjusted Basis (-) Selling Expenses of Sales Commissions and Closing Costs = Realized Capital Gain
- Realized Gain (-) Depreciation (x) 25% = TOTAL (x) 15%* = Recognized Gain
*If property was held for at least 1 year + 1 day and taxpayer bracket is 25% or higher. If property is less than 1 year, add the gain to taxpayer’s income to determine income bracket tax rate. The recognized gain represents the amount of taxes due, which is also the amount deferrable in a 1031 exchange.
Since the depreciation allows the taxpayer to deduct a portion of the asset’s basis annually, reducing the taxpayer’s income tax due, the IRS will recapture (charge back) 25% of what was depreciated. Adding bonus depreciation of 50% and more, the recapture depreciation may be very high.
Will I benefit from an IRS 1031 Exchange when purchasing vacation rental property?
Possibly! Depending on your circumstances, the exchange may help you get out from under a property and use more of the profits from the sale to buy a better, more profitable property!