Real estate investors may think of using a 1031 exchange when managing their real estate portfolio. For example, perhaps you are considering a shift from active management of the property to passive investing. In that case, using a 1031 exchange to defer the payment of capital gains taxes on property you identify for sale may make sense.
The Deferral May Be Continuous
Suppose that an investor decides to sell a commercial property that they have owned for several years, and it has appreciated from $400,000 to $800,000. If the investor sold the building outright, they would owe taxes on the $400,000 in capital gains. Instead, the investor would prefer to reinvest that amount into a new property. By using a 1031 exchange, the investor can sell the original parcel and purchase one or more replacements without paying the taxes due. Suppose that in a few more years, the taxpayer does the same thing. The replacement property has also appreciated, and the investor executes another 1031 exchange, again deferring the payment of the capital gains tax. It’s important to note here that these taxes due are not eliminated or avoided, only delayed.
However, there is a way to eliminate the tax. If the investor either continues employing the 1031 with each subsequent reinvestment or holds on to the property at some juncture until they give it to an heir, the tax will be moot. That is because the heir will receive the asset bequeathed at a stepped-up value, eliminating the need for them to pay a capital gains tax on the appreciation that the previous owner earned and deferred.
Exchanges Have Strict Rules
Only investment property can qualify for a 1031 exchange, and the relinquished property must be "like-kind" to the replacement. That means that both must be held for investment. However, the IRS has been generous with the definition because taxpayers can use almost any type of investment property in an exchange with another. So, a taxpayer can swap a rental house for an office building or a self-storage facility for a hotel. Furthermore, the IRS allows investors to exchange into and out of Delaware Statutory Trusts using Section 1031.
Is a Boat Eligible?
A boat could be eligible for a 1031 exchange under limited circumstances. Suppose the vessel is permanently attached to a dock and functions as a restaurant and hotel, like the Queen Mary in Long Beach, California. That’s a mixed-use hospitality property. In that case, the issue is not likely to be disputed. A commercial fishing boat or charter operation vessel might qualify. That example is not as straightforward as one in which the boat or ship is permanently attached to a structure or land. Investors should seek the advice of a tax professional before proceeding.
