1031 Exchange Explained | Tax Deferral for Investment Sales
Who Pays Capital Gains Tax on Real Estate Sales?
When real estate is sold, the seller owes a capital gains tax on the profit unless one of two primary exceptions kicks in. One exception is for investors and the other is for owner-occupants who relocate and sell their property.
Homeowners live in their homes about seven years on average. As long as they've lived there for two of the last five years (or two of the last ten if they're actively serving military duty), they are exempt from paying capital gains on the profit from their sale in most cases. There are some requirements and limitations, but it's a lot easier for owner-occupant to avoid tax damages than it is for investors!
But investors aren't exactly out of luck, either. The Internal Revenue Service (IRS) is known for complex rules, and one of those tricky sections of tax code - specifically, section 1031 - gives them a bit of an out.
Notice how I used the word tricky? I've found in my career as a Realtor that few investors and many agents and title companies have no idea how to use this tidy loophole. Perhaps that's because using it is so challenging that people simply surrender the opportunity (as I did once when I was unable to meet the timelines), but it's an option I will jump on for my next property sale - a house I plan to unload sometime in the next two years.
In this article, I'll be providing a basic overview of 1031 exchanges and how to use this when your real estate agent may not be familiar with the how-to.
1031s and Starker Exchanges
The term "Starker exchange" is sometimes used to describe a normal 1031 exchange. Prior to 1979, the IRS said that in order for an investor to benefit from this tax boon, he (or she) would have to offload their property and acquire a replacement property simultaneously.
However, this concept was challenged when T.J. Starker sued the U.S. government over the government insisting he had to pay capital gains on about $1.5 million after he entered an agreement transferring his timber land and acquiring a dozen parcels of other investment property. Although Starker lost his case initially, when it was appealed before the Supreme Court, the court found in Starker's favor and determined that acquiring the right to purchase property equated to actually purchasing the property. (See Starker v. United States, 602 F.2d 1341, 79-2 for details on the case.)
The IRS revised its code, and today, all 1031 exchanges are permitted to be delayed exchanges - at least, to a certain degree. Let's take a look at these and other requirements next.
What kind of assets do you have that would likely be eligible for a 1031 like-kind exchange?
Calculate Your Tax Savings - Example
Let's pretend you snapped up an amazing deal on a fantastic duplex that you rented for the last five years, and now you are ready to sell.
Step 1 - Determine Adjusted Cost Basis
Original Property Cost: $ 100,000
Add Improvement Costs: $ 9,000 (it lacked parking, so you paid for concrete driveways.)
Subtract Depreciation Costs: $29,000
$100,000 + $9,000 - 29,000 = $80,000. This is the Adjusted Cost Basis.
Step 2 - Calculate the Realized Gain. Start with the price you're selling for today.
Sale Price: $180,000
Subtract costs of sale: 14,000 (includes real estate commissions, closing costs, etc.)
Subtract Adjusted Cost Basis: $80,000 (this is the figure you calculated above.)
$180,000 - $14,000 - 80,000 = $86,000 Realized Gain.
This is the amount that would be subject to capital gains taxation. Although capital gains are taxed at a lower rate than earned income, any asset held for less than a year is taxed at the same rate (or higher) as earned income.
Step 3 - Calculate Actual Capital Gain Tax Amount
For assets held more than 1 year, capital gains are taxed based on the seller's marginal tax rate. Which tax bracket you're in determines the capital gains tax rate as follows:
33% and lower marginal tax rate = 15% capital gains tax
35% marginal tax rate = 18.8% capital gains tax
39.6% marginal tax rate = 23.8% capital gains tax
Multiply the applicable capital gains tax rate by the Realized Gain to determine how much would be payable to the IRS. In this example, we'll pretend you're at a 33% tax rate, which means a 15% capital gains tax would be applied:
$86,000 x .15 = $12,900 Capital Gains Tax Due that could be used for down payment on another investment property by completing a Starker exchange!
IMPORTANT NOTE: TAX RULES CHANGE FREQUENTLY. THIS ARTICLE USES FIGURES BASED ON 2013 TAX YEAR RATES.
Types of Assets that Can Be Deferred with a Starker Exchange
While my own expertise is in real estate, the IRS considers much more than land and buildings as assets eligible for a tax-deferral. They require that the exchange be "like kind," which can include:
- Investment property like apartments, rental houses, or commercial buildings built for sale
- Farmland, timber, or recreational use lands that produce income
- Vehicles used for generating an income or profit - autos, trucks, planes, boats
- Other equipment like tractors, building cranes
- Chattel such as horses or cattle
- Smaller items as long as they're used as an investment, like coin collections, may be eligible under certain conditions
- Personal property
These items must be exchanged for another investment, but it doesn't necessarily have to be the same product. For example, the owner of an excavating company could sell his bulldozers and purchase a couple of construction cranes without triggering a red flag, but he wouldn't be able to sell the dozers and defer taxes if he purchased a duplex to rent out.
On the other hand, the owner of a water park could sell it and acquire an apartment complex and mineral rights on 100 acres of land, and would be eligible for using the 1031 benefits because the water park, apartments, and mineral rights are all considered real estate.
Although a Starker exchange may be applied to personal property, the taxpayer must be able to demonstrate that an asset meets qualified use standards. In other words, the asset must have been acquired for the purpose of making money - whether as a buy and hold investment or as a tool for producing income.
There are also certain investments that do not qualify.
- Stocks, bonds, mutual funds, cash, or most real estate investment trusts (REITs)
- Shares of stock or ownership interests in a company or partnership
- Personal use property (a vacation home wouldn't qualify as a "buy and hold investment," for example, unless it is also used for income at least part of the year.)
- Purchased for resale property - real estate to be flipped, land that's to be developed, and merchandise inventory bought to be resold in a reasonably short amount of time.
- Some properties in U.S. territories may not qualify.
Many people, including professionals, get confused about the fine distinctions. A major reason for this confusion has to do with the text of the IRS code. It's somewhat vague and it fails to specify a certain amount of time that an asset must be held in order for it to qualify as a "held for appreciation" property. When I was planning my own 1031 exchange, I discovered that even the IRS representatives weren't sure how to answer questions about this! For this reason, I encourage everyone to consult with a highly qualified tax advisor before making assumptions that could prove costly.
Some Advantages and Disadvantages of Starker Exchanges
Defers paying capital gains tax
No access to sale proceeds until replacement sale or 180 days
Deferment can be repeated with subsequent sales
Taxes must be paid eventually*
Replacement may have smaller mortgage for similar property
Rules can be complex - some professionals aren't clear on them!
Can buy better property using funds that would have gone to taxes
Couldn't claim a loss if relinquished property did not have capital gains
Starker Exchanges Still Have Time Limits
Although the code was revised after the Starker lawsuit and the IRS could no longer require exchanges to be simultaneous, there are still limits to how long an investor can utilize the tax deferral method.
- Within 45 days of selling an asset, specific potential replacement assets must be identified in writing.
- Full acquisition of the replacement assets identified must be completed no later than 180 after closing the sale of the relinquished property.
The video shown here describes the process briefly. You may notice she highlights that identified replacement assets don't always work out and that the 1031 must be "rewound" in order to get your money back. She is referring to the proceeds of the initial sale, which the IRS requires to be held in escrow by a qualified intermediary.
This means that when the first sale takes place, the seller-investor doesn't actually get any money until after the replacement property sale is closed. Then, if the investor didn't use 100% of the proceeds to acquire replacement property, those surplus funds will be returned to him, something known as "boot." The value of any personal property acquired in the sale is also boot. Boot is taxable at the normal capital gains rate.
- IRS Tax Form
After a 1031 exchange, you'll need this IRS form to file your taxes. Although your tax pro will have them on hand, this form reveals what kind of information you'll have to keep handy.
- Qualified Intermediary (QI) - Accomodators & Intermediaries
Qualified Intermediary (QI) serves a crucial function under the Internal Revenue (IRS) Code. Choosing a Qualified Intermediary to facilitate the 1031 exchange is usually the first and one of the most important steps.
- 1031 Exchange Fees, Costs and Charges | EXETER 1031 Exchange Services, LLC
Learn HOW 1031 Exchange Fees Costs and Charges are assessed by Qualified Intermediaries (Accommodators) | Understand your 1031 exchange fees | Provided by EXETER 1031 Exchange Services, LLC
How to Complete a Tax Deferred Exchange
Not all title companies or attorneys are equipped to handle 1031 exchanges. Real estate agents may not be familiar with those who do. The IRS requires that a "qualified intermediary" serves as the escrow agent. Because the rules can be so peculiar and no two exchanges are alike, I would encourage anyone considering a like-kind exchange to hire someone with extensive 1031 experience. The costs can vary depending on the type of exchange being completed, but generally will be at least $500.
The intermediary has three basic duties:
- To review all contract information and ensure it complies with IRS regulations.
- To prepare the required Section 1031 forms and paperwork to ensure the deferral is completed without any hitches.
- To hold sale proceeds in escrow until the replacement property sale is completed.
You'll want to identify a qualified intermediary before you sign a contract with a buyer to purchase your property, because certain language must be in both sales contracts - the one for the property you're relinquishing and the one you'll be acquiring. It's possible to hire the intermediary after you're already in contract and to complete an amendment to add the verbiage, but you must have hired your intermediary before you close the sale or you will not be eligible to defer the capital gains. Timelines on these exchanges are very unforgiving!
The basic steps you will have to do are as follows:
1. Hire your intermediary before you offer your property for sale if possible, and no later than completing a sale for the property you're letting go.
2. Follow your intermediary's instructions for identifying possible replacement properties. There are strict rules about dollar amounts and the number of properties that can be identified, so be sure to follow instructions precisely. If you don't, you could find yourself paying capital gains tax even after buying the replacement property.
3. Have your possible replacement properties identified as soon as possible - preferably before your own sale closes. You have a maximum of 45 days to identify what you're buying. Keep in mind that your offer may not be accepted or a sale can fall through for other reasons. Your intermediary and real estate agent should work together to help you make smart decisions here!
4. Close the sale within 180 from the day your own sale closed - in other words, 135 days after the identification period ends, your replacement sale must be completed or you'll be out of luck! Most simple home purchase loans take at least 45 days to close, so if you're considering commercial properties or complex equipment purchases, figure out if you'll have enough time before submitting the property as a possible replacement.
Because a simple error could literally cost you thousands of dollars, I encourage you to pick up a copy of the book below and get very familiar with exchanges before attempting one. This particular book is highly recommended by Thell M. Woods, a certified exchange specialist for over four decades. He says Borden's book "is the first work that treats the subject in the proper manner it deserves." You can buy it from Amazon through the link below.
A Final Word or Two
If your financial plan includes growing wealth instead of squandering it, understanding important tax breaks is vital. The Section 1031 exchanges are one extremely beneficial method of preserving thousands, even hundreds of thousands of dollars over an investor's lifetime. However, there are additional tax-free exchanges that investors can benefit from. Reverse exchanges are a safe harbor that allow you to acquire a replacement property before selling your own investment, for instance, but they present a different set of challenges.
Every large dollar transaction an investor makes is subject to IRS scrutiny and potential taxation. Tax rules change yearly. State and local laws can affect the final results of a sale.
I'm a Realtor and investor. I'm not an accountant, an attorney, or a 1031 qualified intermediary. Always consult appropriate, qualified professionals for your particular situation.