1031 exchange is a tax deferral strategy that allows real estate investors to defer taxes when they exchange one investment property for another. Thus, giving investors an opportunity to save cash and strategically grow their investment portfolio. The Biden Administration proposed a tax law that would eliminate this tax deferral strategy for capital gains over $500,000 for a single taxpayers (1 million for couples). Here we discuss what investors need to know about the tax implications of selling investments and 1031 exchanges.
Selling Real Estate Investments without a 1031 exchange
The sale of an investment property can result in taxable income. After paying tax liabilities, the investor is left with even less to reinvest. However, an investor has the option to use 1031 exchange to reinvest the proceeds of the sale of the investment property and defer these taxes:
- Capital Gains Tax- The gain on the sale of an investment property held for more than a year will be subject to long-term capital gains tax, which can be as high as 20%.
- State Taxes -You may also have to pay a state tax on the capital gain.
- Depreciation Recapture – Additionally, you pay tax on all depreciation deductions, known as depreciation recapture, at the ordinary income tax (up to 25%).
For example, let’s say you purchased a home at the price of $200,000 (cost basis). Over the years, cumulative depreciation deductions of $50,000 lowered the cost basis to $150,000. When selling the property for $500,000 you will deduct the cost basis $150,000 and the cost to sell the property $25,000 resulting in a recognized gain of $325,000. The previous depreciation deductions of $50,000 are recaptured and taxed at an ordinary tax rate (capped at 25% rate) equal to $12,500 tax. The rest of the gain is taxed at the long-term capital gains tax rate (up to 20%). If you are in the 20% capital gains tax bracket, then the tax on the remaining $275,000 is $55,000. You would end up with about $257,000 to reinvest.
|Original Cost (Cost Basis)||$200,000|
|Equals Adjusted Basis||$150,000|
|Less Adjusted Basis||$150,000|
|Less Cost to Sell||$25,000|
|Equals Capital Gain||$325,000|
|Less Tax Liability (Gapital Gains tax $55K and Ordinary Tax $12,00)||$67,500|
|Funds Available for Re-invesment||$257,000|
What are the benefits of a 1031 exchange?
The IRS Internal Revenue Code Section 1031, known as 1031 Exchange, permits an investor (an individual or company) to exchange their investment property for a “like-kind” property without having to recognize a capital gain or loss and defer taxes. This tax law states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Investors can continue to grow their investment as there is no limit on the number of times the 1031 exchange tax deferment method can be used. You may have the opportunity to sell your investment property and exchange it for a larger investment property or want to invest in a different market. As long as you don’t realize a gain, you can continue to defer taxes.
What is a like-kind property?
The term like-kind is used broadly. The term “like-kind” doesn’t mean that the exchange must be made for the same type of real estate property. The investor can choose from different types of investment properties. For example, a farm can be exchanged for commercial real estate. A “like-kind” property is defined by the IRS as “Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land.” In order to qualify for the 1031 exchange both the relinquished property and the replacement property must be held for investment and located in the United States.
The Tax Cuts and Jobs Act of 2017 eliminated personal and intangible property as qualifying investments for 1031 exchanges. As a result, the following types of property are excluded:
- Personal Use Assets- primary residences, second homes(unless it qualifies for safe harbor)
- Property Held for Sale – property acquired for flipping or rehab, property held for development and sale, property acquired for conversion
- Securities- stocks, bonds, mutual funds, real estate investment trusts
- Interest in Equity- partnership interests, membership interests, shares owned in a corporation
Vacation and Second Homes
Vacation homes and second homes can qualify for a 1031 exchange if it complies with IRS Revenue Procedure 2008-16 Safe Harbor Guidelines. The following rules apply to the relinquished (property sold) and replacement property (property acquired):
- Property must be held as an investment for 24 months
- Property must be rented at least 14 days in each 12 month period within the 24 months
- Property can’t be used for personal use for more than 14 days in each of the 12 month periods within the the 24 months (or personal use can’t exceed 10% of the number of days within each 12 month period that the property is used for rental)
How does the 1031 exchange work?
The rules and steps needed to properly execute this tax-deferred exchange depend on the type 1031 exchange, here are four different types:
- Simultaneous exchange- the exchange take place at the same time
- Delayed exchange – the replacement property is purchased no later than 180 days after the relinquished property is sold.
- Reverse Exchange- the new investment property (replacement property) is bought before the original investment property (relinquished) is sold.
- Improvement Exchange- (also known as “build to suit exchange”) the investor can use proceeds from the sale to make improvements on the replacement property.
Delayed 1031 Exchanges
The most popular type is delayed exchange. In this type of exchange, the relinquished property is sold before acquiring the replacement property within a specified time window.
The IRS requires an exchange facilitator or a Qualified Intermediary (QI) to set up the exchange. The Qualified Intermediary (QI) received all funds from the sale of the relinquished property. If the investor receives any funds before the exchange is complete, then the 1031 transaction is disqualified and the funds become taxable income.
You must obtain a QI before the closing of the sale. Your QI cannot be anyone who has served as your agent including anyone who has served as your real estate agent or broker, investment banker or broker, accountant, attorney, or employee within the two year-period ending on the date of exchange transaction.
There are two important time requirements in a delayed exchange (both run concurrently):
45 Day Rule- After the sale of the relinquished property, the investor has only 45 days to designate potential replacement properties
- Three property rule- investors, can identify up to 3 replacement properties (you only have to close one of these properties).
- 200% rule – If the investor designates more than three properties (unlimited) then the combined value of the properties may not exceed 200% of the value of the relinquished property
- 95%rule- the investor can identify many properties as long as the value is 95% of the replacement property.
180 Day Rule – The investor has a total of 180 calendar days to close the purchase of the replacement property.
Qualifying for 121 Exclusion
The IRS Section 121 allows the exclusion of part of the capital gain from the sale of a taxpayer’s primary residence. Single filers can exclude $250,000 gain, and Joint filers can exclude $500,000 gain.
Investors can turn their 1031 exchange investment property into their primary residence and qualify for the 121 exclusion. Of course, they must follow Safe Harbor Rules to ensure that the 1031 exchange isn’t challenged. Additionally, homeowners must hold the property from the date of the exchange for a minimum of 5 years.
Partner with a Trusted Tax Accountant at Eco-Tax
Before completing a complex real estate transaction, like a 1031 exchange, always consult with your advisors. We at Eco-Tax are ready and here to support you through it all. To learn more about how our tax planning services could help you, contact us today to book a free consultation with one of our trusted advisors. We look forward to partnering with you!