The 1031 Exchange: A Powerful Tool for Deferring Taxes
Sec. 1031 exchange activity has picked up considerably in recent years, as real estate sellers facing significant capital gains look for opportunities to soften the tax blow. By exchanging real property for other real property of “like kind,” owners can defer capital gains taxes until the replacement property is sold.
The benefits of the 1031 exchange are substantial because an outright sale of appreciated property can potentially trigger four levels of taxation:
- Federal income tax of 15% or 20%, depending on one’s tax bracket
- 25% tax on “recapture” of previous depreciation deductions
- 3.8% net investment income tax, if applicable
- State taxes
Like-kind property is defined very broadly to include virtually any real property interest held for investment or business purposes (including vacation homes if they’re held primarily for rental income). But it doesn’t include personal residences, land under development, or property held for sale, such as a “fix-and-flip” property.
Sec. 1031 exchanges are also available for interests not commonly viewed as “real estate,” such as air and water rights, conservation and agricultural easements, and “perpetual communications easements” (for cell towers). Until recently, Sec. 1031 exchanges were also allowed for a like-kind personal property, but the recent Tax Cuts and Jobs Act (TCJA) eliminated this tax break.
There’s no bright-line test for determining whether a property is held for investment or business purposes (to generate rental income, for example) or for sale. The IRS considers several factors in making this determination. For example, listing replacement property with a real estate agent or broker shortly after an exchange indicates an intent to sell the property rather than to hold it for investment.
Exchanges by Partnerships and LLCs
When real property is held by a partnership or limited liability company (LLC), the partners or members may have incompatible exit strategies. Some may want to sell while others may want to use a Sec. 1031 exchange to defer their gains. But Sec. 1031 exchanges are available only for real property, not for partnership or LLC interests, which are considered personal property. There are strategies available that allow some partners to cash out and others to defer their gains. In a “drop and swap” arrangement, for example, the entity distributes the real estate to the partners or members in proportion to their interests. The owners end up with tenancy-in-common interests, which they can sell or exchange as they see fit. There are a number of risks associated with this strategy, so careful planning is critical.
Planning Opportunities for Home Sales
The Sec. 121 home-sale exclusion allows you to permanently exclude from income up to $250,000 in gain ($500,000 for certain joint filers) on the sale of your principal residence. To qualify for the exclusion, you must use the property as a principal residence for at least two years during the five years preceding the sale and meet certain other requirements.
There are opportunities to take advantage of both Sec. 121 and Sec. 1031 with respect to the same property. One example: An owner of commercial real estate defers gain by exchanging it for residential investment property in a Sec. 1031 exchange. The owner converts the new property into a principal residence and later sells it, taking advantage of the Sec. 121 exclusion to avoid the gain permanently. Several requirements apply to these transactions. For example, to qualify for Sec. 1031 treatment, one must establish an intent to acquire residential property for investment, which generally means using it for rental purposes for at least two years. Also, to enjoy the benefits of the Sec. 121 exclusion for property acquired in a Sec. 1031 exchange, one must own the property for more than five years.
Full vs. Partial Deferral
If you receive anything other than like-kind property (“boot”) in an exchange, then only a portion of the gain can be deferred. For example, cash boot is taxable immediately, as is “mortgage boot.” Mortgage boot, also known as “debt relief,” arises when the mortgage on the replacement property is less than the mortgage on the relinquished property. For example, if one exchanges property with a $200,000 mortgage for a property with a $150,000 mortgage, there’s $50,000 of mortgage boot, which is taxable.
Sec. 1031 exchanges are subject to various timing and other technical requirements, all of which must be followed to the letter. In a traditional “deferred exchange,” for example, once you close the sale of the relinquished property, you have 45 days to identify one or more replacement properties. The purchase of the replacement properties must then be completed by the earlier of 1) 180 days after the initial sale or 2) the extended due date of your tax return for the year of sale. In addition, to avoid immediate taxation, an independent qualified intermediary (QI) must receive and hold the sale proceeds and acquire the replacement property.
“Reverse exchanges,” in which you acquire replacement property before selling the relinquished property, are more complicated. These exchanges require a special type of QI, called an Exchange Accommodation Titleholder (EAT), which acquires title to the replacement property while the taxpayer seeks a buyer for the relinquished property. Once the EAT receives the replacement property, the taxpayer has 45 days to identify one or more properties to exchange and 180 days to complete the transaction.
QI Due Diligence
Given the critical role of the QI or EAT, it’s critical to conduct due diligence on these providers, particularly since they’re not federally regulated. Questions to ask include: Are funds held in separate accounts or are they commingled? (Separate accounts are preferable.) Where are the funds deposited? What type and size financial institution? What types of accounts? What is the QI or EAT’s financial condition? Is there a financially sound parent company standing behind it? For example, is the QI or EAT a subsidiary of a bank or title company?
Exchanges between related parties, such as family members or entities under common control, must be handled with care to avoid an IRS challenge. These exchanges are subject to special rules, including a requirement that each party hold the exchanged properties for at least two years.
Handle With Care
Sec. 1031 exchanges offer attractive tax benefits, but they’re also subject to a number of technical requirements that must be followed meticulously. If you’re contemplating an exchange, be sure to work with an experienced advisor to plan the transaction carefully and minimize your risk.