For ingenious investors might be well-aware that any mutual fund distributions, whether reinvested or shares exchanged in one fund for shares of another, must usually be reported as income, and any capital gains tax is to be paid. But are you aware that it is possible to defer capital gains? You can do this by taking advantage of a tax break, allowing you to swap your investment property.
Considering the U.S. Internal Revenue Code of Section 1031, a 1031 exchange is defined as the process that allows you to avoid paying capital gains tax. It becomes possible if you sell an investment property, reinvest the gained amount from the sale, and do this within a certain time limit in a like-kind property with an equal or greater value.
Role of Qualified Intermediaries
Under section 1031, any amount received from the sale of a property shall be taxable. Thus, proceeds from the sale must be transferred to a qualified intermediary rather than the property’s seller. The qualified intermediary then transfers them to the seller of the replacement property. A person or company is a qualified intermediary if he agrees to facilitate the 1031 exchange by holding the funds until they can be transferred to the replacement property seller. The qualified intermediary can have no other formal relationship with the parties exchanging property.
Section 1031 Like-Kind Exchanges
The deferment provisions of Section 1031 covered a wide array of the property before the revocation of all property types except a real property by the Tax Cuts and Jobs Act of 2017.
To qualify for Section 1031, the properties to be exchanged must be held for productive use in a trade, business, or investment. As of now, only real estates are included in this section. The exchange must be of the like-kind, which is to say of the same nature or character, although it may differ in grade or quality. Also, note that real property within the United States and real property outside the United States are not like-kind properties. Generally, like-kind properties in terms of real estate include any property that can be classified as a real estate property in any of the states of U.S. or Washington, D.C., and in some cases, even the U.S. Virgin Islands.
A like-kind exchange applying to real-estate is designed for people who want to exchange properties of equal value. If you own a piece of land in Oregon and trade it for a shopping center in Rhode Island, as long as both properties are equal, both are deferred from the capital gains tax even if both the properties may have appreciated since they were originally purchased.
The taxpayers holding real estate as inventories, or purchasing real estate for re-sale, can be considered as the dealers. These are the properties that are not eligible for Section 1031 exchange. If a taxpayer is a dealer and an investor, he can use Section 1031 on qualifying like-properties. Personal property will not be eligible for Section 1031.
Section 1031 transactions do not necessarily involve identical types of investment. It allows you to swap apartment buildings for shopping centers, or raw land for an office.
Much confusion surrounds Section 1031 and second homes because most taxpayers purchase second homes with the expectation of appreciation. It has been ruled that properties purchased for personal use are NOT investment properties, and hence do not qualify for Section 1031 treatment.
There is no set limit to the number of times Section 1031 exchange can be used. You can also roll over the gain from your investment swaps for many years and avoid paying capital gains tax until the property is finally sold. However, remember that the benefit can be deferred, but not exempted.
Properties of Unequal Value
Consider that you have a small piece of property, and you want to trade it for a bigger one, exchanging it with another party. You can make the transaction without paying the capital gains tax on the difference between the property’s current market value and the lower original cost of the bigger property.
This turns out good for you, but the other property owner doesn’t gain with this. Hence, you shall have to pay cash difference or assume a mortgage on the bigger property to make up the value difference. This is known as the boot in the tax trade, and your partner will have to pay capital gains tax on that part of the transaction.
The exchange process could be carried out through an intermediary known as an escrow agent in order to avoid this. And instead of the exchange involving a one-for-one swap, a three-way deal could be performed. Your replacement property can also come from a third party through the escrow agent. Now, the escrow agent juggles through numerous properties in various combinations, to map evenly valued swaps. Under these circumstances, you aren’t obliged to perform an equal-valued barter. Sell property at a profit, or buy a more expensive one, you can indefinitely defer the tax.
When you sell a property, put the cash into the escrow account, allowing the escrow agent to buy another property that you want. They get the title to the deed and transfer the property to you.
Mortgage and Other Debt
Consider Section 1031 exchange. It is important to note the mortgage loans and other debt on the property you are planning to swap. If you hold a $200,000 mortgage on your existing property, but your new property only carries a $150,000, your mortgage liability gets decreased by $50,000 even if you’re not receiving cash from the trade. The Internal Revenue Code considers this boot, and you will be liable for capital gains tax because it is treated as “gain.”
A Section 1031 transaction requires planning and a well-informed professional. Identify your replacement property within the 45 days of selling your estate and close it within 180 days. If your closing gets delayed by any unforeseen circumstances and you cannot close the deal in time, you’re back to a taxable sale.
It is advisable to look for an escrow agent specializing in similar types of transactions. Also, contact your accountant and set up the IRS form ahead of time. Some people sell their property, take hold of the cash, and put it in their bank account. They think that all they have to do is find a new property within 45 days and close it within 180 days, which is not the case. When the sellers have cash in their hands or if the paperwork isn’t done right, you lose the opportunity to use this provision of the code.
Personal Residences and Vacation Homes
As mentioned previously, section 1031 doesn’t apply to personal residences, but the Internal Revenue Code allows you to sell your principal residence tax-free if the gain is under $250,000 (it is $500,000 if you are married).
Section 1031 exchanges can swap vacation homes, but it presents us with a complex situation. Say, for example, you stop going to your ski resort and instead rent it out to a bona fide tenant for 12 months. With this, you effectively could convert the condo to an investment property, allowing you to then swap for another property whenever you need it.
It is essential for you to report under section 1031 exchange to the IRS on Form 8824, Like-Kind Exchanges, and simultaneously file it with your tax return for that particular year in which the exchange took place. You might otherwise be held liable for taxes, penalties, and interest on your transactions.
Some Key Takeaways
While they may seem simple and easy, like-kind exchanges can lay complicated fronts. Every kind of restriction and pitfalls need to be carefully addressed. Do not hesitate to reach out to us for questions regarding the exchange. We will surely help you out. Visit Tax Strategy and Tax Planning for more information.