A 1031 exchange is a vehicle you can use to swap one type of investment property for another. Doing this allows you to limit the amount of tax you have to pay when you make the exchange. Exchanging the type of investment you have through a 1031 exchange allows you to grow your investment without claiming a capital gain or cashing out your investment.
By rolling the investment over from one real estate property to another, you can profit on your investment and not pay tax on the investments until you cash out, often many years later. When you cash out, you will only need to pay one tax, and that is the long-term capital gain rate. While there are many benefits to a 1031 exchange, it is important that you understand how they work to save yourself headaches at tax time.
Understand Depreciation Recapture
If you exchange depreciable property within a 1031 exchange, you may trigger a “depreciation recapture.” This is taxed as ordinary income. Depreciation recapture most often occurs when you exchange a building for unimproved land. If you do this, the depreciation claimed on the building will be considered ordinary income.
You Cannot Use One for Personal Use
These exchanges are meant for use for business and investment properties, not personal homes. There are some ways you can use these exchanges for vacation homes, but these rules have been tightened up significantly in recent years.
Personal Property Cannot Be Used
In the past, it was possible to use personal property, such as aircraft and franchise licenses, as part of a 1031 exchange. New rules set into place at the end of 2017 mean that only real estate can be used.
“Like-Kind” Doesn’t Mean What You Think
These types of investments require a like-kind exchange, but that doesn’t mean that what you are exchanging must be the equivalent to what you own. You can exchange raw land for a strip mall, or one business for another. 1031 exchanges offer a variety of options for investors.
The Exchange Doesn’t Have To Be a Simple Swap
In fact, it most likely will not be. The exchange typically goes through a delayed, third-party exchange, known as a Starker exchange. In this case, you can get rid of your property and an intermediary holds the funds for you. They will then use the funds to purchase the replacement property when you find something you want. You cannot receive any of the funds from the sale of your property. Doing so will break the 1031 exchange.
You Have To Select a Replacement Property
Even though an intermediary will be holding the funds from the sale of your property, you don’t have an unlimited amount of time to determine what to do with them. Within 45 days you must designate the property you want the intermediary to acquire for you. You can select more than one if there are several available, but you must close on one of the designated properties to maintain the 1031 exchange.
You Have a Limited Closing Window
You must close on the new property within 180 days of the sale of your old property to maintain the 1031 exchange. It is important to note that the clock starts ticking on this transaction when you close on your old property, not when you give the intermediary directions on which investments you would like to purchase. This can create a relatively tight time frame if you have not been actively looking for investment.
Any Remaining Cash is Taxed
If you have leftover cash after purchasing the replacement property, it will be taxed. It is considered sales proceeds and generally taxed at the capital gain rate. The taxable capital gains rate you are required to pay depends on your own situation but is generally 15 or 20 percent.
Assets That Aren’t Cash Are Still Assets
Even if you don’t receive any cash after the sale of your property and the purchase of a new property, you may still end up with taxable income. If your mortgage goes down, the difference is considered profit, and you will owe taxes on it. It is important to understand all of the numbers, both on the sale and purchase of your investments, before signing any papers.
Vacation Homes are Complicated
There are a variety of rules that make using a 1031 exchange for vacation homes tricky. The rules were set in place to prevent people from taking advantage of converting their vacation homes to personal homes and delaying capital gains. You can use a 1031 exchange for a vacation property, but there are several steps you need to implement to ensure you are following the rules. If you are holding the home as a rental, it needs to actually be rented. Ideally, it will be occupied by renters for at least one year. It is not enough to be occupied occasionally by you or family and friends.
The IRS uses a safe harbor rule. To prevent them from challenging whether a home qualifies as investment property as part of a 1031 exchange they require that the home be rented to another person for fair rental rates for 14 days or more and that your own use of the home cannot exceed 14 days or 10 percent of the number of days during the 12 month period the unit is rented. These rules must be met for the two years after the exchange.
Ask About the Transition Rule
A 1031 exchange allows the exchange of qualified personal property in 2018 if the original property was sold or the replacement property purchased by the end of the year in 2017. This does not apply when a new property is purchased before the old property is sold.
As you can see, there are many rules set in place when using a 1031 exchange. These rules were developed to simplify and clarify ways you can protect income during investment. While a 1031 exchange may seem complicated, it is actually a very well-defined way to manage investments, allowing you to continue to build your assets without losing profits to capital gains.