Table Of Contents
- 1 The meaning of section 1031
- 2 What Are Some Of The 1031 Exchange Ownership Rules You Need To Know About?
- 3 How is a 1031 exchange structured?
- 5 What is a reverse exchange?
- 6 Death of a Taxpayer during a 1031 Exchange
- 7 1031s for vacation homes
- 8 1031s for estate planning
- 9 Special Rules for Depreciable Property
- 10 What are the tax consequences of an exchange?
- 11 Vesting issues in 1031 exchanges – disregarded entities
- 12 How are mortgages on relinquished property treated?
The meaning of section 1031
1031 exchange is a common term among real estate agents and other investors.
Section 1031 is part of Internal Revenue Service regulations that hold the requirements for people interested in swapping investment property. Most exchanges of like-kind nature are taxable, but section 1031 allows tax deferral at the exchange period. Through the internal revenue code, real estate investors can avoid paying taxes on the capital gain when they buy real property using the proceeds from the sale of the first one. Section 1031, also 1031 exchange, imposes time limits for the exchanges and mandates that the replacements properties have equal or greater value. There are several rules and guidelines which you must follow in order not to get taxed by the IRS or have other complications during your time frame of use!
We take a look at some of these rules in this article
What Are Some Of The 1031 Exchange Ownership Rules You Need To Know About?
The Same Taxpayer Rule in 1031 Exchanges
The same taxpayer rule is fundamental in every 1031 exchange, especially if you want to enjoy tax deferral treatment. The person who sells the relinquished property must purchase a replacement property. Taxpayers can be individuals, LLCs, corporations, or any other entity. Either way, the title of the new property must be the same as the other property.(also read our article concerning 1031 Exchange costs)
Although the same taxpayer rule may seem simple, most investors fail to recognize and implement it. Several factors such as loan requirements, liabilities, and other business aspects may make the same vesting challenging. Regardless, failure to maintain the tax identity hinders the continuity of tax.
Exceptions to the taxpayer rule exist. They apply to investors with disregarded entities for tax purposes.
How is a 1031 exchange structured?
Every 1031 exchange process requires the involvement of accommodators who agree to a property holding arrangement with the taxpayer. They keep the exchange proceeds and taxpayer rights in the exchange.
The accommodator holds the funds in an escrow account to acquire the replacement property. The funds can also pay for closing costs, mortgage loans, or a deed of trust for the one property. However, the money cannot cover debts that are not present in the mortgage of the relinquished property. If it is a build-to-suit-exchange, the funds can aid in capital improvements or the development of vacant land.
The same taxpayer requirement in a 1031 exchange allows separate taxpayer investment. However, that is usually challenging because of the like-kind replacement property requirement. Finding someone else with a property exactly like the one you are selling can be impossible. Such a move can lead to delayed exchange, but you still have to honor the rules of timing.
Investors must acquire replacement property within 180 days after selling the old one using the delayed exchange.
The investor must identify replacement property and inform the qualified intermediary about it in writing within 45 days after the relinquished property sale. The internal revenue code allows the designation of multiple replacement properties identified so long as you pay the entire purchase price of one of them and they meet the valuation requirements.
It is important to note that the two rules run simultaneously. The earlier you designate a property, the sooner you can close on it.
What is a reverse exchange?
Reverse exchange differs from the delayed exchange by allowing the purchase of a new property before the sale of the old one without mandating investors to pay taxes. The timing rules apply, meaning the taxpayer must give up the new property to an intermediary within 45 days and finish the replacement process within 180 days.
The same taxpayer rule and spouses
The same taxpayer requirement mandates that the spouse whose name appears on the title of the relinquished property should be on the replacement property. Your legal advisor might advise you to complete the exchange and wait a few years before adding the other name.
Death of a Taxpayer during a 1031 Exchange
If a taxpayer passes on before completing the exchange process after selling the first property, the deceased estate can complete the process. The estate gets 1031 tax-deferred exchange benefits if there is continuity.
1031s for vacation homes
1031 tax-deferred exchange can also be profitable for taxpayers who own retirement or vacation homes. The process is slightly different. You can avoid capital gains taxes if you start renting out the property – not if you convert it into a primary residence.
There are business considerations to take into account – it only becomes a business property if you professionally conduct yourself with the tenant. The internal revenue code can only recognize the investment real estate property as viable for 1031 exchange if it has tenants.
Moving into a 1031 Swap Residence
The internal revenue service has a safe harbor rule for taxpayers who want to turn a replacement property into a primary residence. The code requires that the taxpayer rents out the personal property for at least two weeks for fair rental. If you keep the property obtained for personal use, you cannot do so for more than 14 days or ten percent of the total duration the property is up for fair rental within 12 months.
Remember, you cannot change the new property into a primary residence to capitalize on the $500,000 exclusion.
1031s for estate planning
Tax deferral treatment in a 1031 exchange is not infinite. Tax liabilities can catch up with investors after some time. However, such responsibilities only remain viable until death. If a taxpayer passes on before selling any property acquired through 1031 exchange, those who inherit the real estate will not incur taxes. They take ownership of the property with the new market value, making 1031 exchanges perfect for estate planning.
Can you do a 1031 exchange on a primary residence?
Real estate properties like primary residence do not meet the exchange treatment requirements. A property that a taxpayer lives in does not count as an investment property unless you rent it out for a significant period. The investor must relocate elsewhere to make the property eligible.
Can you do a 1031 exchange on a second home?
A second home or vacation property has different tax purposes from properties allowed in a 1031 exchange. It can only qualify for the exchange treatment if it provides income as a business property.
How do I change ownership of replacement property after a 1031 exchange?
Buying an exchange property to change the title to the replacement to someone else after completing the process is not advisable for tax purposes. Do not give the replacement property to someone else soon after purchase. The Internal Revenue Service considers such a move non-eligible for 1031 exchange by assuming you did not get it for investment.
Can a taxpayer exchange with another party?
The internal revenue code allows the exchange of property with another party, but they must hold it for at least two years. An attempt to structure the 1031 exchange in a way that avoids that duration can lead to disqualification.
Taxpayers cannot exchange partnership interests or gain a partnership interest unless they use single-member LLC. IRS treats such LLCs as if the real estate belongs to a sole member. The regulations differ for multi-member LLCs. Any partnership that owns real estate and wants to exchange it must not involve the partners – only the LLC. If some partners prefer the exchange and others do not:
- They can acquire multiple replacement properties and discontinue the association. They can then disburse the properties to redeem the other opposers’ interests.
- They can dissolve the partnership before starting the exchange process.
- They can spend less than the exchange value, allocate the gain to the uninterested partners, and liquidate the cash to liquidate partnership interest.
Special Rules for Depreciable Property
A property can wear and tear during its lifespan, and investors can pay lower property taxes by factoring in the costs of such depreciation. The depreciation value is the portion of the investment property cost that the IRS writes off annually. The internal revenue service can recapture those deductions when you sell the property at a fair market value. Engaging in a 1031 exchange can help avoid the accumulated depreciation amount in the taxable income.
What are the tax consequences of an exchange?
Any leftover cash after the intermediaries acquire replacement property is known as boot. The amount is taxable. According to the tax code, it is taxable even if the accommodator sends that money to the taxpayer after 180 days. Such proceeds can come from a direct profit from the sale of loans associated with the property. For instance, if the mortgage on the second property is less than that of the relinquished property, the difference automatically becomes a boot. The Internal Revenue Service considers that amount as income to the taxpayer.
Vesting issues in 1031 exchanges – disregarded entities
Exceptions to the 1031 tax code rule only apply for a disregarded entity. Exchangers who cannot meet the same taxpayer requirement can avoid the implications of the general 1031 exchange rule through the disregarded regulation. Examples of disregarded entities include Delaware statutory trust, revocable living trust, and Illinois land trust.
Changes to 1031 Rules
The internal revenue code allows the following vesting changes in an exchange.
The investor estate can take over an incomplete exchange if the exchanger dies after selling the relinquished property. That must be before getting the replacement property.
The revocable living trust of the exchanger or grantor can acquire the property using the name individually. The rule only applies when the taxpayer’s investment is a disregarded entity.
Taxpayers can acquire property using a single-member LLC after selling the relinquished property. An exchanger can also acquire multiple replacement properties using several single-member LLCs as long as they are a sole member. The LLCs must be disregarded entities.
The taxpayer rule also allows a husband and wife to use 1031 exchange if the property they want to give up belongs to one person. The individual relinquished property is treated as community property, and the title to the replacement property goes to a two-member LLC. The community property qualifies for tax deferment in community property states. The couple must treat the LLC as a disregarded entity.
A business entity can merge out in tax-free reorganization after selling relinquished property and acquire the replacement property as a new business entity.
Adding a spouse who was not on a relinquished property title to a replacement property can lead to partial recognition of capital gain. Divesting relinquished property that a single entity like a business entity or multiparty LLC holds can disqualify the 1031 exchange benefits. The Internal revenue service recognizes the differences in taxpayers who start the exchange and those who complete it, nullifying the tax advantages. However, changing a general partnership to an LLC before the stipulated exchange duration elapses can qualify under the same taxpayer rule.
Can husband and wife do a 1031 exchange?
A tax advisor can give insight for couples who file joint tax returns, do not share the title of the relinquished property, but want part of the title to the replacement property. Such incidences remain an open issue; therefore, the safest approach is to leave the vesting as is during the exchange period or after. The tax identity on the relinquished property should be on the replacement property.
If only one owns the relinquished real estate, buying the replacement property as a partner does not meet the same taxpayer rule. Other scenarios that may not meet the same taxpayer requirement include:
- When a lender wants both spouses on the title of a replacement property, and only one has the relinquished property.
- When both spouses are on the title of the real property and a lender wants only one spouse on the replacement property title.
Confirm the exchange structure with your tax advisor before relinquishing the property to avoid the taxable problem.
How are mortgages on relinquished property treated?
Proceeds from the 1031 exchange transaction can pay off relinquished property mortgage. The amount that pays off the mortgage as realized proceeds is a portion of the exchange value. Investors should replace it with another mortgage or cash payment because exchange funds can only repay loans for purchasing relinquished properties if the property has a deed of trust.
The same taxpayer rule in a 1031 exchange does not recognize foreign properties. It is essential to consult a tax advisor before engaging in any exchange transaction.