IRS code Section 1031 is slowly making its way into daily conversation. The term is bandied about by realtors, title companies, investors and soccer moms. Some people even insist on making it into a verb, as in: "Let's 1031 that building for another."
IRS Section 1031 has many moving parts that the user must understand before attempting its use. There are also tax implications and timeframes that may be problematic. Also, the rule stipulates the 1031 swap like-kind properties and limits the rule's use with vacation properties.
What is Section 1031?
Broadly stated, a 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meets the requirements of 1031, you'll either have no tax or limited tax due at the time of the exchange.
(For background reading, see Avoid Capital Gains Tax on Your Home Sale.)
In effect, you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain. That allows your investment to continue to grow tax-deferred. There's no limit on how many times or how frequently you can do 1031. You can roll over the gain from one piece of investment real estate to another to another and another. Although you may have a profit on each swap, you avoid tax until you sell for cash many years later. Then you'll hopefully pay only one tax, and that at a long-term capital gain rate (currently 15% or 20%, depending on income—and 0% for some lower income taxpayers).
The provision is only for investment and business property, so you can't swap your primary residence for another home. There are ways you can use 1031 for swapping vacation homes—more on that later—but this loophole is much narrower than it used to be.
Special Rules for Depreciable Property
Warning: Special rules apply when a depreciable property is exchanged in 1031. It can trigger a profit known as depreciation recapture that is taxed as ordinary income. In general, if you swap one building for another building you can avoid this recapture. But if you exchange improved land with a building for unimproved land without a building, the depreciation you've previously claimed on the building will be recaptured as ordinary income.
Such complications are why you need professional help when you're doing 1031. Still, if you're considering a 1031—or are just curious—here are 10 things you should know.
Changes to the 1031 Rule
Before passage of the new tax legislation Dec. 22, 2017, some exchanges of personal property—such as franchise licenses, aircraft, and equipment—qualified for a 1031 exchange. Under the new law, only real estate qualifies. Exchanges of corporate stock or partnership interests never did qualify—and still, don’t.
On the other hand, interests as a tenant in common (TIC) in real estate still apply. It’s worth noting the Tax Cuts and Jobs Act (TCJA) full expensing allowance for certain tangible personal property may help make up for this change to tax law.
The TCJA includes a transition rule that permits a 1031 exchange of qualified personal property in 2018 if the original property was sold or the replacement property acquired by Dec. 31, 2017. The transition rule is specific to the taxpayer and does not permit a reverse 1031 exchange where the new property is purchased before the old property is sold.
"Like-Kind" is Broad-Based
Most exchanges must merely be of "like-kind"—an enigmatic phrase that doesn't mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But again, there are traps for the unwary.
You Can Do a 'Delayed' Exchange
Classically, an exchange involves a simple swap of one property for another between two people. But the odds of finding someone with the exact property you want who wants the exact property you have is slim. For that reason, the majority of exchanges are delayed, three-party or "Starker" exchanges (named for the first tax case that allowed them).
In a delayed exchange, you need a Qualified Intermediary (middleman) who holds the cash after you "sell" your property and uses it to "buy" the replacement property for you. This three-party exchange is treated as a swap.
1031 Timeframe Regulations
There are two key timing rules you must observe in a delayed exchange.
- The first relates to the designation of a replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can't receive the cash, or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate replacement property in writing to the intermediary, specifying the property you want to acquire. The IRS says you can designate three properties so long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.
- The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old. Note that the two time periods run concurrently. That means you start counting when the sale of your property closes. If you designate replacement property exactly 45 days later, you'll have just 135 days left to close on the replacement property.
Tax Implication and Mortgages
You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as "boot"—will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
One of the main ways people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property. If you don't receive cash back, but your liability goes down—that, too, will be treated as income to you, just like cash.
Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. You have $100,000 of gain that is also classified as "boot," and it will be taxed.
1031s for Vacation Homes
You can sell your primary residence and, combined with your spouse, shield $500,000 in capital gain, so long as you've lived there for two years out of the past five. But this break isn't a 1031 and it isn't available for your second or vacation home.
2004 Tightening of the Vacation Home Loophole
You might have heard tales of taxpayers who used the 1031 provision to swap one vacation home for another, perhaps even for a house where they want to retire and Section 1031 delayed any recognition of gain. Later, they moved into the new property, made it their primary residence and eventually planned to use the $500,000 capital-gain exclusion.
In 2004, Congress tightened that loophole. Yes, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Example: You stop using your beach house, rent it out for six months or a year, and then exchange it for another property. If you get a tenant and conduct yourself in a businesslike way, you've probably converted the house to an investment property, which should make your 1031 exchange okay.
However, if you merely hold it out for rent but never actually have tenants, it's probably not allowable. The facts will be key, as will be the timing. The more time that elapses after you convert the property's use to rental the better. Although there is no absolute standard, anything less than six months of bona fide rental use is probably not enough. A year would be better.
Moving Into a 1031 Swap Residence
If you want to use the property you swapped for as your new second or even primary home, you can't move in right away. In 2008 the IRS set forth a safe harbor rule, under which it said it would not challenge whether a replacement dwelling qualified as an investment property for purposes of Section 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange:
- You must rent the dwelling unit to another person for a fair rental for 14 days or more
- Your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
Moreover, after successfully swapping one vacation or investment property for another, you can't immediately convert the new property to your primary home and take advantage of the $500,000 exclusion.
Before the law was changed in 2004, an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence. Now, if you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange. In other words, you'll have to wait a lot longer to use the primary-residence capital-gains tax break.