Tax Deferred Exchanges: What You Need to Know
If you're not familiar with tax deferred exchanges, you're definitely not alone. But if you're planning on buying and selling any property, it's time you learned about IRS code Section 1031. It could save you a lot of money! This code is becoming more commonly used and referenced now, although it's hardly a household topic of conversation. Still, more people are making mention of how they can "1031 a building" and get a different one. Essentially, the code allows for the tax-deferred exchange of one piece of business or investment property for another, provided other specific criteria are also met.
But there are a lot of different parts to the code, and just selling one house or commercial building and buying another doesn't necessarily qualify you for any type of tax breaks. There's a like-kind rule, time frames, and you don't want to try to use 1031 with vacation properties, either. So, what do you need to know before you delve into the world of real estate and its tax implications? Here are a few of the things you need to know, about a tax deferred exchanges -- and to stay out of trouble with the IRS, as well.
Section 1031: What is It, Really?
A 1031 exchange occurs when you swap one investment property for another one (i.e. you sell one and buy another one). Generally, a sale of business or investment property will result in the payment of capital gains taxes. Meeting certain criteria means you might not have to pay capital gains tax at the time of the transfer. Instead, you will defer the tax until some point in the future when you liquidate the property.
Rules for Property That Depreciates
If the property is depreciable, you may end up having to pay a "depreciation recapture" that will be taxed as regular income. This is one of many reasons that it's a good idea to talk to a tax professional before you make any real estate moves that might involve a 1031 exchange.
Changes Have Been Made, and Keeping Up is Important
It used to be that there were some types of personal property that were eligible for a tax deferred exchange. You can't do that anymore, though, and you can only make a tax deferred exchange on real estate.
The Broad Meaning of a "Like Kind" Property
Like kind may not really mean what you think it does. Generally, any parcel of real property is considered "like kind" to any other parcel of real property. Have a piece of unimproved land, and want to exchange it for an apartment complex? Sure, go ahead. Tired of that strip mall and want to own a ranch in its place? No problem! Just make sure you get good legal and tax advice before you make your sale and purchase. You don't want to fall into a trap as an unwary investor.
An Exchange Can be Delayed, if You do It Right
If you handle things with a middleman (known in the trade as an intermediary) you can sell one property, have the cash held for you, and then buy the new property when you're ready. That still counts as an exchange, but you can't just sell something and keep the money in your personal account, with the plan to buy something later. Without the middleman, the delayed exchange falls apart.
There are Regulations on Time Frames
If you decide on a delayed exchange, there are time frame rules you have to be aware of. For example, you have 45 days to find identify another property and tell your middleman about it, in writing. You can pick up to three that you're interested in, but be aware that you have to close on one of them within the time limitations or your tax deferred status will go away. There are also different rules if you want to identify more than three properties. Also, you also have only 180 days to close on the property you're buying, and that clock starts ticking as soon as the old property is sold.
Mortgages and Their Tax Implications
Keep in mind that cash left over after completing the tax deferred exchange will be taxed, because that money will go to you.
What About That Vacation Home?
It used to be pretty easy to buy and sell vacation homes, and still get tax deferred status. But the IRS cracked down on that in 2004, and now it's much harder to do. It also takes a lot longer, so most people skip it and just use Section 1031 for investment properties -- which is what the rules were intended for. But if you have a vacation home you really do want to get rid of, you can still do a tax deferred exchange. You just have to follow the rules, including renting out the property for a period of time before trying to sell it.
The general rule is that the property must have been held out for rent for at least two years prior to the exchange, with strict limitations on the number of days you can occupy the house for personal use. Then you could legitimately claim it as an investment property for the purpose of a tax deferred exchanges, and you could sell it and purchase a different property with the proceeds. If you later decide you want to live in the house you bought in the exchange, the same two year rules and limitations on personal use apply.
Well, there you have it. A thumbnail sketch of some of the issues surrounding 1031 tax-deferred exchanges. This isn't an exhaustive list of the rules and regulations, though, so make sure you contact your tax professional if you have any questions. Following their advice is the best choice to make sure you're handling your exchange the right (and legal) way.