Using a 1031 exchange to defer the payment of capital gains taxes on the sale of investment property is an attractive tool for many investors. Successful execution of the exchange will allow a taxpayer to defer paying taxes on the capital gain that an investment property has accrued. Naturally, the IRS is specific about what does and doesn't qualify for this favorable tax treatment. Taxpayers must judiciously adhere to the stipulations to reap the benefits.
How does a 1031 exchange work?
When an investor sells property that is an investment or used in business, if the value has increased since the purchase, that increase is a capital gain. Short-term capital gains (imposed if the investor has owned the asset for less than one year) are assessed at the same rate as the investor's rate for ordinary income. However, long-term capital gains rates apply if the investor has owned the asset for over a year. Long-term capital gains tax rates are lower than the rates for ordinary income.
Investors can defer the payment of these taxes (and the amount due for depreciation recapture, if any) by selling the identified property using a 1031 exchange. The name refers to the applicable section of the tax code, and to succeed, the taxpayer must carefully follow the rules. The regulation is detailed, and the primary requirements include:
1. Use a Qualified Intermediary (a neutral third party unrelated to the taxpayer) to manage the transaction and hold the funds in escrow.
2. Reinvest the entire proceeds into new investment property within 180 days of selling the asset targeted for disposition (the relinquished asset).
What happens when the investor sells the replacement property?
When the investor sells the property they purchased to replace the property sold in the 1031 exchange, they will owe both the deferred taxes and capital gains taxes on any appreciation in the new property’s value. Let’s look at an example:
Joe has a rental house that he has owned for five years. His basis in the property is $500,000, and the current value is $800,000. Rather than pay the capital gains tax on that $300,000 gain, Joe uses a 1031 exchange to replace the rental property with a self-storage facility, for which he pays $800,000. He defers the taxes. If Joe owns the self-storage unit for two years and then sells it for $900,000, he will owe the deferred taxes on the original rental house sale and the taxes now due on the new deal.
If Joe uses another 1031 exchange instead to replace the self-storage unit with something else (also an investment property), he can continue the deferral. If Joe continues to employ the 1031 exchange for future dispositions until he distributes the final investment asset to an heir, he can effectively eliminate the accrued taxes. That outcome is possible because the heir receives the property at its current (stepped-up) value.
How quickly can an investor sell a replacement property?
This question illustrates one of the ambiguous areas in tax law. The IRS states that property is not eligible for a 1031 exchange if the taxpayer holds it for immediate sale or disposition but does not define immediate. The IRS says that the intent of the investor decides on the eligibility.
However, many professionals advise that investors retain the replacement property for at least a year or two.
Investors may also eventually transition an investment property to personal use, but they should be careful about establishing the intent. Suppose that the investor has exchanged office property for a residential rental. Later, the investor decides to live in the rental. Suppose they have demonstrated the intent of the original acquisition by renting the property to others for at least two years. In that case, the IRS will likely allow the conversion without disallowing the 1031 exchange.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.