Another popular avenue for funding a real estate investment is utilizing a 1031 tax deferred exchange. During the recession when appreciation was non-existent there were no gains for buyers and sellers to defer but in the current market, the use of the 1031 has made a strong return.
As a 1031 exchange is a handy tool for deferring income tax on the sale of real estate, I thought you might desire more details about the program. As typical for any IRS code, the description material tends to be dry so reading this article may function as a sleep aid as well.
What is an IRS Section 1031 Tax Deferred Exchange? Quite simply, it allows you as the owner of investment property (almost all property that is not your personal residence or second home) to sell the property and buy another investment property, deferring the tax on your capital gains. You do not have to find someone to accept your property in trade for the one you sell. A simultaneous close is not required.
The investment property being relinquished must be owned by the exchanger for a least 24 months prior to the exchange and must have been held for investment purposes during that entire holding period. You must keep good documentation to evidence the “held for investment” purposes. Further, the owner can not violate the fair market rental and personal use of the property rules.
The new property acquired by the exchanger must also be used as an investment property for at least 24 months after the acquisition. Some articles I have read state 12 months is adequate, if it shows on the exchanger’s tax file for 2 filings; timing is important.
During the holding period the property, if rented, it must be at fair market rental rates and the exchanger’s personal use of the property must not exceed the greater of 14 days or 10% of the time the property is rented out at fair market rent during a 12-month period.
This is workable with a vacation rental especially when time spent by the exchanger at the property to make repairs is not counted as personal use as long as it meets the rules. The exchanger must work on the maintenance and repairs the lesser of 8 hours or 2/3rds of the time the exchanger is on the premises. This is a tricky area so you should check with your CPA about the documentation required.
You should also check with your CPA about renting to family members, it is possible, but you want to make sure you are well documented.
The steps for performing an exchange are not significantly different from those for completing a standard sale. You list the property, hopefully with me, and then market it for sale just like any other property. A Buyer is located, and escrow is opened. A 1031 Intermediary is brought into the transaction prior to closing. The existing property is closed but the net proceeds are held by the intermediary. When a suitable replacement property is closed, and the exchange is concluded.
When considering the sale of income or investment property, you as a seller must consider the taxation. When selling property, you could owe federal and, in some areas, state capital gains tax. This could mean paying 20% to 40% in taxes on the gain. Instead of paying a large amount to the IRS in taxes you can use that money to buy more real estate. Property that qualifies for preferential tax treatment under Internal Revenue code section 1031 (IRS 1031) is treated quite differently. IRS Section 1031 states:
“No gain or loss shall be recognized if property held for productive use in a trade or business or for investment purposes is exchanged solely for property of a like-kind”. Investors do not have to exchange for exactly the same type of property as they relinquished. “Like-Kind” does not refer to the nature, character, or type of property, but just that it also be held for productive use or for investment purposes.
Therefore, if using IRS section 1031, you can exchange raw land for a rental home, an apartment complex, or for a shopping center. The use of the property is the factor in determining the tax treatment and the property must have been initially acquired and held for either business or investment purposes.
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Written by:
Merri Ann Simonson – Managing Broker
Coldwell Banker San Juan Islands, Inc.
317-8668 cell
