Have Questions? Talk to an Expert First
1031 Exchange Made Simple
How To Sell an Investment Property
And To Save on Taxes
Many of you have probably heard about the IRS Section 1031 commonly known as “1031 Exchange” which allows to defer capital gain tax when selling a property used for business or investment purposes and reinvest the proceeds of the sale in a “like-kind” replacement property. Here are 5 things you need to know if you are contemplating a 1031 exchange.
1. The Net Price
In order to defer all capital gain, your net purchase price must be greater than your net sales price. As an example, a property sold for $800K may have a net sales price of $750K after commissions and other qualified closing costs. A purchase of at least $750K is required to defer all capital gain tax. If you buy a property of lower value than you sold, you will be liable for taxes on the difference (this is known as “boot”).
In addition, all the equity (proceeds) must be used towards the replacement property. Any proceeds left over after the exchange is completed are also known as boot and taxable.
Usually, boot is in the form of cash, an installment note, debt relief or personal property and is valued to be the “fair market value” of the non-like-kind property received. It is important to understand that the receipt of boot does not disqualify the exchange; it then would become what is known as a partial 1031 exchange AKA partial deferral.
Below are 2 examples of partial deferrals:
Scenario Number One - Taking cash at the sale of the relinquished: Lila is selling her rental townhouse for $1,000,000. At the close of escrow, she wants to receive $100,000 to invest in the stock market and utilize her remaining funds for her 1031 Exchange. The $100,000 is not part of the tax deferred exchange. If the seller takes any cash from the sale, that amount becomes taxable boot.
Scenario Number Two - Buying down in value: Lila is selling her rental townhouse for $1,000,000 and plans to utilize a 1031 Exchange to defer her taxes. However, she can only locate new property with a sales price of $800,000 that she desires to purchase. The $200,000 not reinvested into like kind property will be taxable.
2. The Like-Kind Property
Any real estate property is considered to be like-kind with another real estate property as long as both the properties sold and purchased are used for investment or business purposes. A primary residence or a second home cannot be used in a 1031 Exchange. Property purchased for resale, such as “flipped” homes also do not qualify for 1031 Exchange. Single-family rental homes, condos, commercial property, farm land, bare land held for business or investment purposes, located in the United States, are like-kind and can be exchanged. You can also buy and sell multiple properties within one exchange.
For most exchanges, the identification rules are not
difficult to follow. But what happens if
the property or properties the taxpayer plans on identifying do not easily fit
into the rules? Let’s look at a few
3. Identifying Uncommon 1031 Property
Scenario Number One: The Three Property rule tends to be the
most widely used for identification. Most taxpayers attempt to identify three
properties or less to stay within the Three Property rule. But what if a
taxpayer desires to identify a building with an adjoining small warehouse and
two parking lots that are located on the sides of the buildings? Is the
taxpayer identifying one or four properties?
There is no guidance provided in the 1031 regulations or
rulings; although Revenue Procedure 2002-22 provides that the IRS will
generally treat contiguous parcels of real estate as comprising a single
business unit or “property”. However, it
is very important to note that this Revenue Procedure was issued in the context
of co-tenancies and does not directly apply to the identification rules.
Notwithstanding, many tax advisors consider three factors to
determine what makes multiple lots one property for identification
purposes. These are:
1/ The properties are contiguous;
2/ The properties have a common ownership and are being sold
under one contract; a
3/ The properties are economically connected (have a unity of
Examples of being economically connected might be an office
building and an adjacent parcel that serves as a parking lot for the office
building or a residential rental and a vacant lot next door which serves as an
extra side yard. However two single
family rentals located next to each other would not have a unity of use because
they are separate economic units.
Scenario Number Two: A taxpayer identifies 500 acres of
farmland but later determines that he really needs only 420 acres. Is the
identification still valid?
Can I buy less property than I identified?
Yes, with a limitation. There is an example in the
regulations where a taxpayer identified a two acre parcel of land but only
bought on and a half acres or 75% of the property identified. The regulations stated that the taxpayer
acquired substantially what was identified. However, the IRS does not consider it a plus or minus rule. Stated differently, you cannot acquire more
property than what was identified. The
reasoning is, that the additional portion was never identified. Accordingly, it is not like kind and cannot
be acquired with 1031 Exchange funds.
Where in the regulations does it say I cannot identify 100%
of a parcel but purchase only 60% of what I identified in my 1031 Exchange? It does not. However,
regulation 1.1031(k)-1(d)(ii) provides that the identification requirements are
satisfied if “the replacement Property received is substantially the same
property as identified”. Example 4
(referenced above) states that 75% is substantially the same. But what about 70% or 60%. This is a question that must be answered by
an exchanger’s tax advisor.
4. The Deadlines
From the date escrow closes, there are two statutory deadlines. You have 45 calendar days to identify the property you are going to purchase and 180 calendar days to close on your replacement property. There are no extensions for weekends or holidays. If the 45th or 180th day falls on a Sunday, it still remains your deadline. When identifying a property, you can use either the Three Property Rule (i.e. identify up to 3 properties regardless of their value) or the 200% Rule (i.e. identify as many properties as you want up to an aggregate fair market value of 2 times what you sold).
5. The Accommodator
In a 1031 Exchange, you must use a Qualified Intermediary (“QI”), also known as the Accommodator or Facilitator. The QI must be assigned into the contract on the property you are selling before escrow closes. Once escrow closes, the QI will hold the proceeds from the sale of the property. These proceeds are restricted for certain periods. You may withdraw proceeds before funds are sent to the QI, but withdrawals will be taxable boot.
In an nutshell, investors usually use a 1031 exchange for the following reasons:
They can use what they would have paid in capital gains taxes to put more down on a replacement property to improve their buying power;
The savings on federal capital gains taxes could be 15 to 20 percent;
There could be savings at the state level (this varies by state, so your qualified intermediary should be consulted for this information;
The amount of income taxes paid could be reduced due to depreciation of the investment property.
Feel free to contact me if you have more questions about this increasingly popular way of swapping your assets at a reduced tax rate.
Source: Ron Ricard - IPX 1031 -firstname.lastname@example.org
Source: Russell Barnett - EA - svtaxcoach.com