The 1031 Exchange - An Overview
There may be no better tax incentive for investment real estate than the 1031 Exchange. Named in reference to section 1031 of the Internal Revenue Code, the “1031 Exchange” allows an income tax free (or tax deferred, see below) exchange of investment real estate with wide latitude.
HOW A 1031 EXCHANGE WORKS / TAX FREE VS. TAX DEFERREDThe 1031 Exchange allows for no capital gains taxes at the time of the transfer; However, if the subsequent property is later sold without another 1031 Exchange, then taxes will be due (absent other exceptions such as inheritance or gift tax). Thus, many refer to the 1031 Exchange as *tax deferred* not as *tax free*.
That said, in conjunction with other estate planning mechanisms (i.e. gifting and inheritance), a 1031 Exchange can be utilized to help eliminate or reduce overall estate taxation. There is no limit on the number of 1031 Exchanges.
THE BASIC RULESThe Exchanger must not receive any of the money, even for the temporary purpose of purchasing the new property. For this reason, a third-party is required to assist with a 1031 Exchange (and technically take possession of the property, the money exchanged and reinvested into the new property, after which title is transferred back to the owner).
Three other key rules apply (with many unique circumstances that warrant consultation with a 1031 professional):
(1) Acquire *like kind* Replacement Property that will be held for investment or used productively in a trade or business
*Like Kind* can apply to virtually all forms of investment real estate in the United States (residential, commercial, agricultural, etc.), with exclusions for purley development properties (i.e. you cannot purchase real estate specifically to develop or *flip* and resell the same). The intention of the incentive is to exchange real property investment assets to hold or use, not an incentive for new construction or redevelopment.
(2) Purchase Replacement Property
(a) of equal or greater value;
(b) reinvest all of the equity, and;
(c) obtain the same or greater debt on the Replacement Property.
In other words, the entire value must be replaced, not just the profits, or taxes will be due on the difference (aka *boot).
*Boot* is essentially anything not rolled-over and is taxable.
Debt may be replaced with additional cash, but cash equity cannot be replaced with additional debt. Thus, you cannot take cash profits and *exchange* with debt. All the cash must be rolled over.
(3) Follow the Required Timelines
Exchange must be completed within 180 days (i.e. from the sale of the first property until closing on the purchase of the second).
Exchange Property must be *identified* within 45 days of the sale of the first property (i.e. must inform some third-party to *identify* which property you are exchanging).
This short timeline to *identify* the property realistically means the process must be concurrent. In other words, someone thinking of a 1031 Exchange should be working on the sale of the existing property and the purchase of the new property simultaneously. If you sell the first property and are unable to close on a new property in time, you will owe the full taxes on the sale.
EXAMPLESExample No. 1 * No *Boot*:
An eighteen-unit apartment complex in Denver, purchased for $300,000 many years ago, sells today for $4mm. The owner purchases (or *exchanges* for) a Newport Beach beachfront duplex, for $4mm. The owner will owe zero capital gains taxes on the $3.7mm gain from the Denver apartment complex.
Subsequently, the owner can pass the Newport Beach beachfront duplex to his or her heirs via gifting and/or estate planning, potentially with zero capital taxes ever due on the profit (if the total estate is under current limits, $11.18mm as of April 13, 2018).
Example No. 2 * with *Boot*:
A Newport Beach bayfront estate, used as a rental and investment property, is sold for $8mm with $6mm in profits. The owner purchases a Bed & Breakfast in Maine for $6mm and keeps $2mm from the sale. The owner will owe capital gains taxes on the $2mm *boot* (i.e. the difference between the sale price of the Newport Beach bayfront estate and the purchase price of the B&B), but the owner will not owe any capital gains taxes on the $6mm in profits.
Thus the 1031 Exchange remains incredibly beneficial, even if all funds are not fully rolled into the new property, aka a *partial exchange*.
NEW TAX LAW CHANGES / ONLY APPLIES TO REAL ESTATEEffective January 1, 2018, the 1031 Exchange only applies only to real estate assets. This was a dramatic change as part of the recent tax overhaul. Previously, other forms of assets could be exchanged, i.e. artwork for real estate, etc.; this is no longer the case, only real estate can be exchanged.
The recent changes underscore uncertainty with the future of the 1031 Exchange. Indeed, many have called for the elimination of this incentive entirely and any future congress could further restrict the 1031 Exchange*s benefits. Those considering a 1031 Exchange should discuss the same with their real estate and legal professionals.
SECOND HOME, VACATION HOME, CONVERSION OF INVESTMENT TO PERSONAL OR PERSONAL TO INVESTMENTGenerally speaking, a vacation home or second home does not qualify for either the sale or purchase property in a 1031 Exchange. That said, if the property is a true investment and not for personal use, it may.
To qualify as a Relinquished Property, the property must have been owned for twenty-four months immediately before the exchange, and within each of those two 12-month periods the owner must have 1) rented the unit at fair market rental for fourteen or more days, and 2) restricted personal use to the greater of fourteen days or ten percent of the number of days that it was rented at fair market rental within that 12-month period.
To qualify as Replacement Property, the owner must own the home for twenty-four months immediately after the exchange, and for each of those two 12-month periods the owner must 1) rent the unit at fair market rental for fourteen or more days, and 2) restrict personal use to the greater of fourteen days or ten percent of the number of days it was rented at fair market rental within that 12-month period.
*Personal use* includes use by the Exchanger*s friends and family members that do not pay fair market value rent (but would not be included if they pay fair market value rent).
CONCLUSIONThe 1031 Exchange is potentially the best tax incentive for investment real estate; it can be combined with other forms of estate planning and potentially even used for properties that later become (or at one time were) second homes under the right timelines and compliance with other requirements.
The recent changes in federal tax law underscore uncertainty with the future of the 1031 Exchange. Investors looking to buy or sell in Newport Beach, Costa Mesa and countless other communities with explosive growth in property value should explore the benefits of a 1031 Exchange with their real estate professional.
Lucas Real Estate readily assists investor clients with their 1031 Exchanges, especially in the areas of Newport Beach, Costa Mesa and coastal Orange County California.
Author Devin R. LucasAuthor Devin R. Lucas is a Real Estate Attorney, Broker and REALTOR*, specializing in Newport Beach, Costa Mesa and Orange County coastal communities, serving individual and investors in residential real estate. Courtney Lucas, licensed CPA, Real Estate Salesperson and REALTOR*. Devin Lucas and Courtney Lucas work in conjunction with Villa Real Estate, the area*s leading luxury brokerage.
Lucas Real Estate
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