Pay No Income Tax When You Sell Investment Property With a Tax-Deferred Exchange
Investors can qualify and pay no income tax when they sell property (including real estate) with a 1031 Exchange. Section 1031 of the Internal Revenue Code code lets you sell your investment property and buy a new property without paying any taxes.
Investors must follow the 1031 exchange rules and should use the services of a bonded and insured 1031 exchange accommodator.
What is a 1031 Exchange? The Internal Revenue Service in 1990 initiated rules on Tax-Deferred Exchanges. Section 1.1031 of the Internal Revenue Code laid out the procedure for turning a sale and purchase type transaction into an exchange.
1. Exchanges can be used only for investment properties or properties owned for use in a business. They can’t be used for residences or for second homes unless the property is used only for rental to third parties. 2. Exchanges must be made between like-kind properties. 3. To meet the IRS guidelines for an exchange, you must identify the replacement property for the one you exchange within 45 days of the initial property transfer date. 4. Investors must close on purchase of replacement property within 180 days from the initial transfer date of your property to the other party.
Pitfall – Once you relinquish your property to the new owner, you have just 45 days in which to either: (1) take possession of the new property, or (2) create a legal document that lays out the terms of the exchange, identifies each property by its official name, and is signed by the parties involved. All exchanged properties must be officially closed within 180 days or the tax benefit may be disallowed.
If the property exchange isn’t simultaneous, you must use a qualified intermediary – a licensed and bonded exchange accomodator – or bank or an attorney – to hold the money until the other part of the exchange is complete.
6. If you end up with cash to even out the value of the two exchanged property (called a “boot”), that cash is taxable at current capital gains rules.
7. All exchanged properties must be located in the United States.
8. If the property you receive in exchange is from a person related to you, and you then sell the property within two years, the original exchange will not qualify for deferred capital gains.
These rules allow owners of certain types of like kind investment Real and Personal property to sell their property and buy other like kind property without paying the Capital Gains Tax.
The like-kind provision for real property is broad, and includes Land, Rental, and Business property. Any of these can be exchanged for the other. The like kind provision for personal property is more restrictive. This type of property must be in productive use in a business (depreciable property), and can only be exchanged for the same type of property.
Example: A business aircraft for a business aircraft (a fixed wing airplane for a helicopter will work), or a commercial truck for a commercial truck, etc. The rule also required that the “Exchanger” use a safe harbor to hold the proceeds while the exchange was in progress, and spelled out what those safe harbors were.
The practical safe harbor for most “Exchangers” is a “Qualified Intermediary”. What qualifes for a 1031 exchange? QUALIFIED PROPERTIES – The classification of properties exchanged determines if the property qualifies for Section 1031 treatment.
A. The IRS’s 4 classifications of Real Estate:
Property held for personal use. (Personal Property and not qualified)
Property held primarily for sale. (Dealer Property and not qualified)
Property held for productive use in a trade or business. (Business Property and qualified)
Property held for investment. (Investment Property and qualified) Both the property received and the property sold must be of “Like Kind”. It is your use of the property that determines its classification. What the other party does with the property does not affect your tax status.
B. Like-Kind Property Like-kind refers to your use of the property and not to its grade or quality. “1031? property may be mixed as to type and still be like-kind. Example is that you may exchange land for a duplex, or a commercial building for a retail store, etc.
However, property held outside the USA and its territories does not qualify for exchange with property held within the USA. C. Partnership Interests Your interest in a partnership cannot be traded for an interest in another partnership. Exception: The partnership as an entity can exchange real estate it owns for other like-kind real estate.
D. Transfer Between Spouses – There are no income tax consequences in entering into financial transactions between spouses. In addition, most transfers incident to a divorce are tax free. However, transactions with a former spouse are normally subject to tax unless they qualify for non-recognition of gain under the provisions of Section 1031.
E. Sale/Lease Back As An Exchange A lessee’s interest in a lease with a term of 30 years or longer in real property is considered like-kind to other real property. In addition, property which is subject to a lease can be, even if the lease is for a term of 30 years or longer, the subject of a tax free exchange. However the receipt of prepaid lease payments in an exchange for a 30-year or longer lease is taxed as ordinary income and will not qualify for tax-free exchange treatment.
F. Business Assets – The personal property assets of one business can be exchanged for like-kind assets of another business and will be held as a like-kind exchange under Section 1031. The real property is treated the same as any other exchange.
The like-kind requirements for personal property are much more stringent than for real property (e.g., a truck cannot be exchanged for a car, nor can a barge be exchanged for a cargo ship).
G. Vacation Homes & Properties. This type of property does not qualify if it is used solely for personal use. It may qualify if rented, and must pass a use test each year.
H. Limitation. A taxpayer who exchanges under 1031 into a rental house as a replacement property that is later converted into their primary residence, is not allowed to exclude gain under principal residence exclusion rules of IRS 121 unless the sale occurs at least five years from the date of its acquisition.
The result is additional requirement to IRC 121 that anyone exchanging into rental property when they subsequently convert to personal use will have to wait at least five years from acquisition before they can sell it as their residence and exclude any gain under IRC 121(a). This is effective for principal residence sales occurring on or after October 22, 2004.
A taxpayer who exchanges under 1031 into a rental house as a replacement property that is later converted into their primary residence, is not allowed to exclude gain under principal residence exclusion rules of IRS 121 unless the sale occurs at least five years from the date of its acquisition.
The result is additional requirement to IRC 121 that anyone exchanging into rental property when they subsequently convert to personal use will have to wait at least five years from acquisition before they can sell it as their residence and exclude any gain under IRC 121(a).
This is effective for principal residence sales occurring on or after October 22, 2004.
I. Extensions of Time. 120-day extensions of time for filing dates are available to parties in a like-kind exchange if their properties fall within a region designated for federal disaster relief.
J. California law re Tax-Deferred Exchanges – California handles 1031 exchanges the same as the U.S. government does.
By Harrison K. Long – This is for information only and is not the providing of legal or tax services. Source of some information is the Internal Revenue Service. 1031 exchanges are complicated. You should always use the services of an exerienced real estate attorney and income tax professional when making such plans and decisions.
Connect with us about listing and selling Orange County CA homes and real estate.