One of the many benefits of owning real estate is the ability to write off mortgage interest and a portion of one’s property tax liability. But, if you own a home or other residential property as an investment, you could be able to take advantage of a 1031 exchange. A 1031 effectively allows you to defer payment of capital gains taxes, using it to facilitate an increased return on your investment over time.
These tax-deferred exchanges are part of Internal Revenue Code (IRC) Section 1031, also called a Starker Exchange, enacted in 1921 as part of The Revenue Act of 1918. Not limited to real estate, a 1031 exchange can be used for both personal and real property, providing a powerful exception to the rule of having to pay taxes on profits made at the time of sale.
Utilizing a 1031 exchange for a residential real estate transaction necessitates specific requirements are met. Some of these are listed below.
- The property cannot be a primary or secondary residence; they must be for investment purposes only. The new tax laws enacted in late 2017 make this very clear as outlined in our March blog about real estate and new tax laws.
- The property must be in the United States.
- There must be an exchange of properties and not simply a sale of one and purchase of another, which is a taxable transaction.
- Though Section 1031 states property exchanged must be “like-kind”, this term covers a broad swath for real estate. One could exchange a duplex for a residence to be used for investment purposes or an apartment building for vacant land.
- The exchange can include property plus “boot”, which can include debt relief, cash, or not like-kind property. Boot is often used to make up the difference in value of an exchange. All boot is taxable so an exchange involving receipt of boot is not 100% tax deferred.
- Two time limits must be adhered to in order to qualify for a 1031 exchange:
The seller has 45 days from the date the original property is sold to pinpoint prospective replacement properties. This must occur in writing and there are also detailed documentation requirements.
The replacement property must be received and the exchange completed no later than 180 days (6 months) after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. This is called a delayed exchange and requires a ‘middleman’ who will hold the money received from the “sale” of the first property and uses it to “buy” the replacement property. This three-party exchange is considered a swap.
- The exchange must be reported to the IRS and filed with your tax return for the year in which the exchange occurred.
There is no limit on the number of times or the frequency a residential real estate investor can utilize a 1031 tax-deferred exchange. By postponing the payment of capital gains taxes, the investor can continue to allow profits to grow over many years and ultimately, pay one tax at the long-term capital gains rate, which are lower than rates for short-term gains. A long-term investment is defined as being held for more than one year with a tax rate typically between 15 and 20 percent while short-term gains (anything held for less than a year) are taxed at normal income tax rates.
It is important to use a real estate agent and a facilitator who understand the intricate complexities of 1031 exchanges. If you are interested in pursuing a 1031 exchange or would like more information, The Dawn Thomas Team can help.