The truth of the matter is that capital gains taxes can eat up a large chunk of profit when you sell an investment property. It’s not an easy pill to swallow.
But this is where the 1031 exchange comes in. In most cases, a 1031 exchange represents an intriguing opportunity to defer your capital gains taxes until a future date.
With changes under the Tax Cuts and Jobs Act (TCJA) and some state-level changes under California Assembly Bill (A.B.) 91, it is important to determine if a 1031 exchange is a viable tax strategy for you.
If it is, you could leverage it as a wise tax and investment strategy, as well as a valuable estate planning tool.
What is a 1031 Exchange?
A 1031 exchange, also known as a like-kind exchange, is a tax-deferred transaction that allows for the disposal of a real property asset and the acquisition of another similar real property asset without generating a capital gains tax liability from the sale of the first asset. The Internal Revenue Service (IRS) permits the transaction through Internal Revenue Code (IRC) Section 1031 and requires strict adherence to IRS requirements.
To qualify as a 1031 exchange, the transaction must take the form of an actual exchange rather than the sale of one property and the subsequent purchase of another.
1031 Exchange Key Terms
Constructive Receipt: If you receive cash from the sale, it triggers immediate taxation called “constructive receipt.” In order to avoid this tax, you may involve a Qualified Intermediary to facilitate the transaction.
Like-Kind: According to the IRS, properties are like-kind if they are of the same nature or character, even if they differ in grade or quality. For example, an apartment building would generally be like-kind to another apartment building.
Qualified Intermediary: A Qualified Intermediary (QI) is one of the safe harbor provisions provided by the IRS. The QI acts on your behalf as a facilitator in the 1031 exchange. In effect, the QI holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. The QI must be an independent third party and ideally is not your attorney, agent, broker or CPA.
Relinquished Property: The Relinquished Property is the property you own at the beginning of the exchange. This is the property you wish to dispose of.
Replacement Property: The Replacement Property is the property you intend to acquire in the exchange.
How did the TCJA Impact the 1031 Exchange?
Significant tax reform in 2017 altered the qualifications for a like-kind exchange. More specifically, the TCJA limited 1031 exchanges to only real property used in a trade or business or for investment.
Previously, taxpayers were able to utilize a 1031 exchange and defer taxes on like-kind exchanges of real or personal property. Generally, like-kind exchanges with personal property involved aircraft, boats, automobiles, trucks, and machinery or equipment. Then, a taxpayer could benefit from deferring gain on the like-kind exchange personal property under the former rules. However, as just mentioned, this is no longer the case.
The IRS describes on their website, “exchanges of machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and intangible business assets generally do not qualify for non-recognition gain or loss as like-kind exchanges.”
Now, as of January 1, 2018, the disposal of personal property and its exchange with other personal property of like-kind is a taxable event.
Note, there are some exceptions. The IRS explains that “certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain or loss as like-kind exchanges.”
Also note that the TCJA now excludes property described in Section 1245, like furniture and equipment, while property described in Section 1250, such as chandeliers, ceiling fans, and electrical circuits, are not considered personal property and are eligible for a 1031 exchange.
What are Some of the 1031 Exchange Rules?
In order to take advantage of a 1031 exchange, you must account for certain 1031 exchange rules and best practices. These include:
As previously noted, a 1031 exchange involves the disposal of one asset and the acquisition of another similar asset. This like-kind exchange features real property of the same nature or character, regardless of grade or quality.
Both the Relinquished Property and new Replacement Property must qualify under IRS specifications. This means that you cannot sell your personal residence and expect 1031 tax deferral benefits. Rather, the property must be used in your business or trade, such as a place of business or office facility, or be an investment property.
Some examples of like-kind real estate include:
- A hotel for an office building;
- Commercial property for unimproved property;
- An industrial building for a multifamily property;
- An office building for a shopping center;
- A condo unit for a warehouse;
- A farm or ranch for an apartment building;
- A duplex for a Tenant in Common investment.
Furthermore, you can exchange unimproved raw land held for investment purposes for a rental investment property. This may include:
- A shopping center for raw land; or
- Undeveloped land for an industrial building.
If you held the property as an investment, it is irrelevant whether the land is productive, improved or unimproved. Any mixture of office buildings, parking lots, apartment buildings, shopping centers, retail stores, hotels, motels, farms and ranches or unimproved land are eligible for exchange.
Like-kind exchanges under Section 1031 are limited to property within the United States. In addition, a vacation home or second home that you do not hold as a rental usually does not qualify for a 1031 exchange.
1031 Exchange Rule #2: Time restrictions do exist.
In like-kind exchanges, you must follow stringent time restrictions for the transaction. Overall, you must use the proceeds from the sale to purchase the replacement asset within 180 days of the sale of the relinquished asset. However, you must identify the property or asset you are purchasing in the 1031 exchange within 45 days of the initial sale.
More specifically, upon the sale of the Relinquished Property, the 45-day identification period commences. You must either close on or identify in writing a potential Replacement Property within 45 days from the closing and transfer of the original property.
Following the 45-day identification time, you have 135 days remaining to close on the new Replacement Property. Therefore, you must complete the entire exchange within 180 days (45 + 135 = 180).
It is important to remember that this time period is nonnegotiable, includes weekends and holidays, and there are no exceptions. Failure to complete the transaction in the designated amount of time disqualify your entire exchange with taxes sure to follow.
1031 Exchange Rule #3: Your Replacement Property should be of equal or greater value.
In order to completely avoid paying taxes on the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than, the property sold. Otherwise, you will not be able to defer 100% of the tax.
There are three common ways to identify your Replacement Property:
- Identify up to three properties regardless of their fair market value;
- Identify unlimited properties as long as the combined value does not exceed 200% of the property being replaced; or
- Identify unlimited properties as long as the properties acquired are valued at 95% or more of the property being replaced.
1031 Exchange Rule #4: Avoid “boot” to avoid taxes.
Realistically, most investors follow a three-property rule so they can complete due diligence and select the property that works best for them. Generally, the goal is to trade up in value to avoid the transfer of “boot” and keep the exchange tax-free.
“Boot” is the money or fair market value of any additional property you receive through the exchange. Money includes all cash equivalents, debts, liabilities to which the exchanged property is subject.
It is “non-like-kind” property and the rules governing it are complex. Without expert advice, receiving “boot” can result in taxes.
1031 Exchange Rule #5: The exchange must involve the same taxpayer.
Perhaps unsurprisingly, the tax return and the name appearing on the title of the Relinquished Property must be the same as the tax return and title holder of the new Replacement Property.
The exception to this rule occurs in the case of a single member limited liability company (LLC), which is considered a pass-through to the member. In this instance, the single member LLC may sell the original property, and that sole member may purchase the new property in their individual name.
What are the 1031 Exchange Rules in California for 2020?
As part of California A.B. 91, signed in July 2019, California conformed to the TCJA changes made to IRC Sec. 1031 that limit like-kind exchange rules. However, the change only applies to exchanges completed after January 1, 2019.
Furthermore, the bill eliminates like-kind exchange treatment for exchanges of personal property by limiting like-kind exchange treatment only to real property, except for individual taxpayers with adjusted gross income of less than $250,000 for a single filer and $500,000 for a joint filer.
How Can Squar Milner Help?
When it comes to optimizing a 1031 exchange strategy, you need a partner by your side who knows the ins and outs of the transaction. Squar Milner boasts a robust Real Estate industry practice to assist you with you real estate and estate planning needs.
Our team has considerable experience in the real estate space. We can help you navigate numerous tax consequences and alternatives, like a Qualified Opportunity Zone, to minimize, defer or eliminate taxes. Our focus is maximizing after tax profits and available cash, and our team is here to strategize with you.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.