So you want to do a 1031 Tax Free Exchange. Or your client has heard something about some kind of tax savings regarding investment property. Or better yet, your investor client has never heard of anything like this, and you can bring this awesome nugget of information to their attention, making you the most knowledgeable, professional, value added realtor they have ever met. If any of these three people is you, read on...
What is a 1031 Tax Free Exchange? NO TAXES, YEA! (BUT ONLY IF.....)
Under 26 U.S.C. Section 1031, "No gain or loss shall be recognized if property held for productive use in a trade or business or for investment is exchanged for property that is to be held for productive use in a trade or business." WHAT?
Basically, if you want to sell a piece of investment property and buy another one for investment, you don't have to report gains or losses on the sale of the first property IF LADIES AND GENTLEMEN, you follow some pretty sticky rules.
So, what are these sticky rules?
Your intent matters. The purpose of the property has to be for investment, not personal use. How do you know if it is for investment? Well, what did you intend for it to be? There is no magic amount of time you need to hold the property. If you have some knowledge of investment property, you might think the holding period is one year. This is because the reduced long term capital gains rates apply for property held for over a year. However this is a different beast. For example, if you intend to hold the property as an investment, but you can't find any renters and have to sell, you have a good argument for intent. I say argument because if you get audited by the IRS, you have the burden of proof.
The property must be "like kind". "Like kind" does not mean it has to be alike. A single family investment home can be exchanged for an apartment building. An apartment can be exchanged for undeveloped land. It is the nature and character of the property, and again, the test comes down to intent to hold for investment. Interestingly, flippers and developers are out of luck. If you intend to buy, fix and flip, you don't qualify for the 1031 exchange.
The dates will make or break you. It's not easy to complete a 1031 exchange. That doesn't mean you shouldn't try, but you must adhere to a strict timeline. First, after you sell your investment property, you have 45 days to identify replacement properties. When I say identify, I mean the address! You must know what you intend to buy within 45 days of closing and don't keep it a secret: tell your qualified intermediary. Second, you must buy that property within 180 days after you sell OR by the time you file your taxes. If you sell your property in December, you must buy your new one by tax day (yes, you are shortchanged but you can file an extension.)
Get yourself a third party qualified intermediary. Someone who doesn't represent you must hold the money until you find something to buy. Don't give it to your attorney, personal banker, spouse, accountant or hide it under your mattress. Your title company may be a good option, but check references and qualifications.
You may still have some tax. If you choose to take some money out of the transaction, or "boot", that's fine, but you will be taxed. Also, unless you trade up in value and equity, you may have some tax gains. For example, if your new property is worth more than the old one (yea), but you take on more debt to pay for it (darn), you might owe some tax.
My takeaway for investors: Know this is out there, and know there are rules. If your business plan is to move from 10 single family homes to one apartment building to reap the benefits of economies of scale, ask your attorney or accountant about the 1031 exchange when the idea hits you. The sooner you make a plan, the more likely you are to crush the time line and save yourself some dough.
My takeaway for realtors: Know this is out there, and bring it to the attention of your investor clients at your initial meeting or listing appointment. This probably won't work if they bring it up at the closing table (remember those dates?). No, you are not an attorney, but you are a knowledgeable real estate professional who is adding value to the transaction. Advise them to talk to their attorney or accountant for details on how this can be financially beneficial.
I hope you find this as exhilarating as I do. Is there anything better than saving money on taxes? If you jump through these hoops, your wallet or your client will thank you.
Peace, love and real estate,
Erika