Understanding 1031 Exchanges: Frequently Asked Questions
A 1031 Exchange is a powerful tool for real estate investors looking to defer capital gains taxes while reinvesting in like-kind properties. The exchange allows you to sell one investment property and acquire another of similar nature, without immediately recognizing a gain or loss for tax purposes. Below, we cover some of the most frequently asked questions about 1031 exchanges to help you navigate this complex but beneficial strategy.
What Qualifies for a 1031 Exchange?
Any real estate held for productive use in a trade, business, or for investment can qualify for a 1031 exchange. This includes various types of investment properties, from single-family homes to office buildings or raw land. Importantly, the properties must be of “like-kind,” meaning they share the same nature or character, even if they differ in quality or type. For instance, you could exchange a rental home for a commercial building or vacant land for an apartment complex.
However, some assets do not qualify for a 1031 exchange, such as:
– Personal residences
– Stocks, bonds, and securities
– Partnership interests
– Property held for sale (e.g., fixer-uppers or inventory)
What Is Excluded from a 1031 Exchange?
Properties held primarily for sale, such as homes built by a developer or properties flipped for profit, do not qualify. Additionally, assets like stocks, bonds, and notes are excluded, even if used for business or investment purposes.
A 1031 exchange also generally doesn’t apply to personal residences, although portions of a property used for business or investment could qualify. This is a common strategy for individuals with home offices or rental units attached to their primary residence.
How to Start a 1031 Exchange
Getting started with a 1031 exchange is relatively straightforward. First, consult with an exchange facilitator, also known as a qualified intermediary, who will help guide you through the process. Be prepared to provide details on the property being relinquished and the potential replacement properties. The exchange facilitator ensures that funds and transactions adhere to IRS rules and that you avoid constructive receipt of the funds, which could trigger tax liability.
Time Limits in a 1031 Exchange
Once you close on the sale of your relinquished property, you have 45 days to identify potential replacement properties. You then have a total of 180 days to complete the purchase of the new property. This tight timeline makes it crucial to be organized and prepared to act quickly when identifying and acquiring new assets.
How to Choose a Facilitator
Selecting a qualified intermediary is essential for a successful 1031 exchange. You can find facilitators through real estate agents, CPAs, attorneys, or online resources. It’s important to ensure the facilitator is not also acting as your agent (e.g., escrow agent or attorney). Look for facilitators with a strong reputation, experience, and proper security measures like a fidelity bond or qualified escrow account to protect your funds.
Identification of Replacement Properties
When identifying replacement properties, you must follow one of three rules:
1. Three-Property Rule: Identify up to three properties of any value.
2. 200% Rule: Identify more than three properties as long as their combined value does not exceed 200% of the relinquished property’s value.
3. 95% Rule: Identify more than three properties with a combined value exceeding 200% of the relinquished property, as long as 95% of the value is acquired.
Costs Involved in a 1031 Exchange
The costs associated with a 1031 exchange vary based on the complexity of the transaction. A simple delayed exchange can start at $1,000, while more complex scenarios, such as reverse or improvement exchanges, may cost upwards of $6,500.
Vacation Homes and 1031 Exchanges
Vacation homes can qualify for a 1031 exchange if they meet the requirements outlined by the IRS in Revenue Procedure 2008-16. The property must be held for at least 24 months and rented out for a minimum of 14 days each year. The homeowner’s personal use of the property must not exceed 14 days or 10% of the days it is rented.
Related Party Transactions
Related-party transactions are allowed under strict guidelines. The IRS imposes a two-year holding period for both the buyer and seller when exchanging with a related party. These rules are designed to prevent tax avoidance through “basis shifting.”
Converting an Investment Property into a Primary Residence
It is possible to convert an investment property into a primary residence and eventually sell it using the Universal Exclusion under Section 121 of the tax code. To take full advantage of this strategy, you must own the property for at least five years and live in it for two of those years. This allows you to exclude up to $250,000 of capital gains as an individual or $500,000 as a married couple.
