Real Estate MauiNow, Ask the Expert: What Are the Benefits of a 1031 Exchange?
Tax aficionados may be able to spout Internal Revenue code sections and forms, but most of us never get beyond Form 1040. Still, “Section 1031” is slowly making its ways into daily conversation, tossed about by realtors, investors and surfers.
Although some might identify 1031 as the best time for a coffee break, a 1031 exchange (also called a like-kind exchange) is actually a swap of one business or investment asset for another. Although most swaps are taxable as sales, if you come within 1031 guidelines, you’ll either have no tax or limited tax due at the time of the exchange.
In effect, you can change the form of your investment without recognizing a capital gain. That allows your investment to continue to grow tax-deferred. You can roll over the gain from one piece of investment real estate to another and another, creating a snowball affect.
You avoid, or defer, tax until you actually sell the investment for cash years later. This allows the taxpayer to keep the “earning power” of the deferred tax dollars working for him or her. Many buyers are turning their attention to single-tenant, triple-net properties (known as STNL deals) for their replacement asset for the security of an investment-grade asset.
Here are a few reminders:
A 1031 isn’t for personal use. The provision is only for investment and business property, so you can’t swap your primary residence for another home. There are ways you can use a 1031 for swapping vacation homes, but this loophole is much narrower than it used to be.
But wait… some personal property qualifies. It can get confusing. Most 1031 exchanges are of real estate. However, some exchanges of personal property (for example, a painting) can qualify. Interests as a tenant-in-common (sometimes called TICs) in real estate qualify.
“Like-kind” is broad. You can exchange an apartment building for raw land, or a ranch for a strip mall. But there are traps at every turn. The term refers to the nature or character of the property rather than its grade or quality (so real property is not considered like-kind to personal property).
You must designate replacement property. Within 45 days of the sale of your property, you must designate replacement property in writing to the intermediary, specifying the property you want to acquire. You must close on the new property within 180 days of the sale of the old.
If you receive any cash, it’s taxed.
Don’t get tricky, because it has probably been tried before you even thought of it. The IRS knows.
Some have attempted to use a 1031 to swap one vacation home for another. Later, they moved into the new property, made it their primary residence and eventually planned to use the $500,000 capital-gain exclusion. Congress tightened the loophole. Please consult your CPA and legal advisor prior to selling your property so you have all the facts ahead of time.
So is a 1031 exchange a tax-free exchange? Well, courtesy of the IRS website: “Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.”
Taxpayers should be wary of individuals promoting improper use of like-kind exchanges. Typically, they are not tax professionals. Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes. Many promoters of like-kind exchanges refer to them as “tax-free” exchanges, not “tax-deferred” exchanges.
Taxpayers may also be advised to claim an exchange despite the fact that they have taken possession of cash proceeds from the sale. These are all red flags and another reason why you should consult with your financial and legal advisor prior to selling your property.
A 1031 tax-deferred exchange is an excellent investment tool for property owners. Investment properties are great additions to any asset portfolio; they can be held to generate income and appreciate in value.
If you have any further questions regarding this topic, contact Keoni Fursse, CCIM, R(PB) and the Kokua Realty LLC investment team at (808) 280-6556.