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What investors need to know about 1031 exchanges

Legal compliance & taxes

A byzantine world of tax rules awaits investors when it comes to selling properties. But sticking to the basics of one popular tool to maximize profits and avoid capital gains taxes has proved to be one of the best bets for building foundational real estate wealth.

It’s called a 1031 exchange. And it’s a tax-deferring transaction that can be used in just about any property portfolio

What is a 1031 exchange?

A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows an investor to avoid paying capital gains taxes on the sale of an investment property, as long the proceeds are reinvested within certain time limits.

1031 Exchange rules and regulations

This tax-saving mechanism works in a variety of ways as long as these rules are followed. 

  • It is a swap of properties that are held for business or investment purposes. (Houses that are flipped do not qualify.)
  • If used correctly, there is no limit on how many times or how frequently an investor can execute a 1031 exchange.
  • The rules can apply to a former primary residence under very specific conditions.

Case study shows how a 1031 exchange works

For an example of a 1031 exchange, let’s say Jeff owns a waterfront rental condo in Miami that he bought for $300,000. The value has shot up to $1 million over the years, and he’s ready to sell. Now, Jeff has his eye on a four-unit villa complex on an upscale golf course in Scottsdale, Ariz., that is on the market for $1 million.

Under a 1031 exchange, he puts the $700,000 profit toward the purchase of the villas at closing, deferring his taxes until the villas are sold (unless Jeff executes another 1031 exchange).

Several requirements must still be met, but the process becomes less daunting with a qualified agent handling the sale. 

History and politics of the ‘like-kind’ exchange

The 1031 exchange, also referred to as like-kind exchange, has been in the tax code since 1921 and has undergone tweaks under various administrations in the last century. The Trump administration’s Tax Cut and Jobs Act, passed in December of 2017, excluded certain personal property and intangible property, limiting 1031 exchanges to real estate property.

As of Jan. 1, 2018, the IRS reported, “exchanges of personal or intangible property such as machinery, equipment, vehicles, artwork, collectibles, patents, and other intellectual property generally do not qualify for nonrecognition of gain or loss as like-kind exchanges.”

The Biden Administration has proposed cutting 1031 exchange deferral limits to $500,000 per year ($1 million for couples filing jointly), but it’s uncertain if it will survive in his final infrastructure package. If the Biden limit passed, Jeff would be required to report $200,000 in capital gains. 

The requirements to qualify for the tax break

It's necessary to exchange one rental for another rental. An investor cannot use the 1031 exchange to sell a rental home and then buy a piece of land that isn't attached to income. And she cannot sell a rental home and then use the 1031 exchange to buy a vacation home. 

The qualified intermediary, who holds the escrow exchange fund, plays an important role in this process. If an investor touches any of the money made when she sold a property, she will immediately be subject to paying taxes. Spending the money or moving it into an investor’s account would incur penalties; such actions void the 1031 exchange.

A section 121 exclusion can save even more

Thanks to Section 121 of the Internal Revenue Code, the taxpayer is entitled to a $250,000 (if single) or $500,000 (if married filing jointly) exclusion on the sale of any property they own and have used as a primary residence (also known as a “principal residence”) for 24 out of the last 60 months. With an exclusion, it isn't necessary to pay taxes or reinvest. These 24 months also don't have to be spent consecutively. 

Like a 1031 Exchange, it's prudent to consult with a real estate professional before performing a Section 121 Exclusion to make sure it is done correctly. 

There are several ways in which the 1031 exchange and a Section 121 exclusion can complement one another. Here’s an example.

  • An investor buys a property and lives in it for two years. Then she moves out and converts it into a rental.
  • The property is kept as an investment for 18 months.
  • When the rental property is sold, an investor can use the Section 121 Exclusion and the tax deferrals from the 1031 Exchange. 

121 Exclusion and 1031 exchange with allocation

An investor can also combine a 121 Exclusion with a 1031 Exchange when a portion of a business property serves as a primary residence. 

For example, an investor owns a four-unit rental property, lives in one and rents out the three others. The investor can still use the 121 Exclusion and 1031 Exchange as outlined above, except the part used as a principal residence would need to be “allocated” when performing the 1031 Exchange.

When performing the 1031 Exchange, the investor will allocate the principal residence part and apply the Section 121 exclusion toward the proceeds from that part rather than the whole complex, which means that only the income from the principal residence portion will be eligible for the Section 121 Exclusion. The three remaining units’ income would go toward the 1031 Exchange's new property.

What is a Delaware Statutory Trust?

The legal entity known as a Delaware Statutory Trust (DST) allows for a number of investors to pool money together and hold fractional interests in the trust. It became a more popular vehicle for pooled real estate investment after a 2004 IRS ruling that allowed ownership interests in the DST to qualify as a like-kind property for use in a 1031 exchange and avoid capital gains taxes

A DST is similar to a limited partnership where a number of partners combine resources for investment purposes, but a master partner is charged with managing the assets that are owned by the trust. Similar to a limited partnership or LLC, the DST offers owners the advantages of limited liability and pass-through income and cash distributions to the minority owners.

Again, it is best to consult with a tax professional when setting up legal entities like a DST.

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