One significant benefit of a 1031 exchange is that you can indefinitely exchange real estate and defer capital gains taxes. However, taxes are deferred, not eliminated, unless the property is held until death, at which point heirs may receive a step-up in basis, potentially avoiding capital gains taxes altogether. As long as you find the right property, you could continue to generate tax-advantaged benefits through this process.
Still, selling real estate through a like-kind exchange is complex. Conducting a subsequent exchange and maintaining tax-deferred status requires understanding the IRS rules and deadlines.
Recap of 1031 Exchanges
Internal Revenue Code Section 1031–” Exchange of Real Property Held for Productive Use or Investment”--lets you “exchange” real estate you hold for investment or business purposes into like-kind real estate of equal or greater value.
Under the IRS rules, a 1031 exchange does not generate a constructive receipt, meaning no sale occurs. Furthermore, no sale means no recognized gain, allowing you to defer capital gains taxes and depreciation recapture payments.
If you continue exchanging one property for another, you could indefinitely maintain that tax deferral. However, many IRS rules and procedures are connected with 1031 exchanges to prevent abuse. Understanding the laws regarding the subsequent sale of a 1031 exchange replacement property is essential to help return your tax-deferred status.
Selling Replacement Property Through a Like-Kind Exchange
The exchange process for an asset acquired through a previous 1031 exchange is similar to the initial process employed to acquire that asset. One determination is that the property fits the IRS’ definition of “qualified use.” In other words, the asset must be held for investment or business purposes to be eligible for potential tax deferral.
If your property fits the “qualified use” definition, your next steps would be to:
- Engage with a Qualified Intermediary (QI).
- Sell the replacement property (which is now the relinquished property).
- Identify a new replacement property within 45 days of selling the relinquished asset.
- Close on the replacement property within 180 days of selling the relinquished asset.
Considerations in a Subsequent 1031 Exchange
While the process of a subsequent like-kind exchange doesn’t differ from the original exchange, there are additional factors to consider:
Cost basis: You must calculate the current basis of the relinquished property. This comes from the adjusted basis of the relinquished property from your first exchange and any additional cash minus deferred capital gains and expenses. The current basis provides the foundation for calculating future capital gains or losses when you exchange the asset.
Depreciation recapture: Depreciation recapture is typically deferred through a like-kind exchange. However, constant deferrals could result in accumulated depreciation deductions, which are taxed at ordinary income tax rates.
Capital gains: There are two capital gains issues involved with repeat exchanges. The first is gains generated from the sale of your current relinquished property. The second is deferred gains from previous 1031 exchanges. Tracking these values can help you anticipate what you owe when you sell a property and cash out.
1031 Exchange Reinvestment Strategies
One reinvestment strategy is using the proceeds of a relinquished property to acquire a replacement property of equal or greater value to fully defer capital gains taxes. Here are others:
Diversification: You could invest the relinquished property proceeds into lower-value replacement properties in other niches or markets. This requires using the 200% rule to identify as many properties as you want, as long as their aggregate value doesn’t exceed 200% of your relinquished property’s value.
Improvement: Proceeds from the relinquished property can also be used to purchase a lower-value replacement property. Capital improvements could then increase the value of the replacement real estate. This could be a practical approach if you run across a replacement property in an emerging market with appreciation potential. All improvements must be completed within the 180-day exchange window to count toward the replacement property’s value.
Delaware Statutory Trusts: Delaware Statutory Trusts (DSTs) are legal entities that buy, manage, and sell real estate. The IRS also considers them 1031 replacement properties. A DST allows you to exchange the relinquished property’s proceeds for shares in the trust. This process provides you with fractional ownership interests in different real estate types. DST investors cannot participate in management decisions but receive passive income distributions from trust operations.
When to Sell a 1031 Exchange Property
Is a specific hold time required before selling a relinquished asset through a subsequent like-kind exchange? The short answer is no. The IRS doesn’t have rules regarding the length of the holding period.
However, most 1031 exchange experts recommend a hold period of at least two years. This is enough time to demonstrate your intent to use the property for investment or business purposes. A shorter hold time could increase the chances of IRS scrutiny, as it could raise questions about whether you owned the property as an investment or were interested in flipping it. Flipped properties are not eligible for 1031 exchange treatment.
Using the Subsequent 1031 Exchange Process
Selling property previously acquired through a 1031 exchange can be an effective strategy if you want to continue deferring taxes. However, any like-kind exchange should include input and assistance from professionals familiar with the process. Having experts by your side lets you confidently navigate the complex steps of an exchange. That can minimize errors and help ensure a successful transaction.
If you desire to keep going with capital gains tax deferral, the proceeds from the sale must be reinvested in another like-kind property as permitted by the IRS within the required timelines. If these requirements are unmet, there would be a taxable event, and the exchange would not be beneficial. Also, the involvement of intermediaries, tax consultants, and real estate experts may assist in the arrangement of the transaction in the right manner and in a legal and favorable way to the IRS concerning the exchange.
The strategies, tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
