At True Title, we field questions similar to this one often:
“My clients are selling their personal residence and getting ready to buy a new one. They want to know if they can defer capital gains taxes by making a 1031 exchange. What do I tell them?”
Here’s the (relatively) short answer to this question: your clients won’t pay capital gains if the house is sold for $250,000 or less (single person) or $500,000 (married couple), but that’s not because of IRS provision 1031 (see IRS Code 121).
With IRS Section 1031 only applying to “like kind” investment property transactions, 1031 exchanges are not an option with regard to the buying and selling of personal residences.
You still are well-served, in our humble opinion, to be more knowledgeable about the 1031 exchange process, so let’s go beyond our (relatively) short answer to review the process in a little more depth.
But, before we begin, our lawyers have asked me to share the following – True Title Company, LLC (and Title Exchanges Services, LLC) and their respective employees cannot provide legal and/or tax advice regarding 1031 tax-deferred exchanges or otherwise; the information provided herein is for general educational and introductory purposes, and you (and your clients) should always consult with legal counsel and/or your accountants for specific guidance on 1031 exchanges and all real estate tax-related matters.
Though we won’t be able to cover every topic related to the detailed process of effectively executing a 1031 Exchange in accordance with IRS guidelines, we’ll share the basics here.
To make things clearer, we’ll guide a fictional client — we’ll call her “Ameera” — through the basic 1031 process steps.
What is a 1031 Exchange?
The “1031” stands for “Section 1031 of the Internal Revenue Code (IRC).” It says:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
There’s a lot there to unpack, but here are the basics:
When our hero, Ameera, sells her property — one used for a business, a trade, or as an investment — she can take the proceeds and roll them into an account held by a Qualified Intermediary (more on this entity later).
Ameera then has a short time in which to identify and purchase another property — once again, a “like kind” property used for a business, trade, or as an investment — using the proceeds from the previous sale.
The words “like kind” in the tax code refers to property that is “held for investment” or “for use in a trade or business.”
Real-life examples “like kind” property swaps include (but are not limited to):
- Raw land for a shopping center sold and exchanged for an apartment building.
- A warehouse sold and exchanged for a retail or restaurant building.
- A hotel sold and exchanged for a productive farm.
The beauty of a 1031 Exchange is this: When done correctly, Ameera defers paying capital gains tax on the proceeds from her sale. She gets to leverage all of her money to upgrade or diversify her investment. She can, among other things:
- Buy property in an area she thinks will appreciate faster.
- Buy up to three different properties, or in some cases even more, to diversify her investment.
- Divest herself of the building in which she operated a business in favor of re-investing in an income-producing building with tenants.
- Much, much more—as long as it’s a “like-kind” exchange.
She or her successors will eventually pay taxes on the investment, but not until they cash out, meaning they could technically keep rolling over their profit from one property to the next indefinitely.
And the capital gains obligation could expire if she is still the owner at the time of her death. Her “heirs at law” will generally be entitled to a stepped-up tax basis based on the value of the property at the time of her death.
However, a 1031 Exchange isn’t a spur-of-the-moment decision. She’ll need to get her ducks in a row before moving ahead to avoid any real trouble. But first, let’s clear up what a “gain” is. Then we’ll line out how to avoid paying taxes on it.
What is a Capital Gain?
When a taxpayer sells a property and has a “gain,” it’s a “capital gain” (or “taxable gain”) and subject to taxation.
However, it’s important to note that a “gain” is not the same as profit. Our hero, Ameera, can make a profit without having to report a “gain.” And Capital Gain Tax Rates are pretty high, ranging from 15-20% at the Federal level and between 0 and 12.3% at the state level.
Our goal is to make sure Ameera walks away from this deal with a profit but without paying any taxes. First, we need to determine what her Capital Gain would be, based on this formula:
Selling Price – Adjusted Basis = Capital Gain.
So, yes, there’s math. But hang in there.
“Selling Price,” of course, means the price you sold the property for. The “Adjusted Basis” is a little trickier.
- First, we start with the “basis,” or the amount Ameera purchased the property for.
- We ADD the amount she paid to make improvements.
- We SUBTRACT the amount that the property has depreciated.
If Ameera wants to calculate her potential “Capital Gain,” here’s the process:
- How much did she pay for the property initially?
- How much did she invest in improving the property? ADD that amount.
- How much did the property depreciate? SUBTRACT that amount.
- That’s the adjusted basis.
Now, how much will she sell the property for? That’s the “Selling Price” part of the equation. Returning to our original equation: Selling Price – Adjusted Basis = Capital Gain.
Now, let’s guide Ameera through the process of rolling that capital gain into a 1031 Exchange.
What are the basic rules for making a 1031 Exchange?
Rule #1: Both the property Ameera is selling, and the property she’s acquiring, must be “held for investment purposes” (i.e., for appreciation in value, for rent, or for business use).
Big caveat: Primary Residences are not eligible for a 1031 Exchange! Vacation homes can be eligible, but the seller will need meet certain requirements first.
Rule #2: Ameera must use the services of one of the following to handle the transaction, so that she never directly accesses the proceeds:
- A Qualified Intermediary (i.e., “QI”).
- A Qualified Trust.
- A Qualified Escrow Account.
The only exception would be if Ameera engages in an actual swap. For example, Ameera gives her property to another investor, and that investor gives his property of equal value to Ameera.
Rule #3: If Ameera receives proceeds from the sale, no matter what she plans on doing with them, she’ll have disqualified the transaction as a 1031 Exchange. (That’s why Rule #2 is so important.)
Rule #4: Ameera must enter into an Exchange Agreement on or before the date of transfer of the Relinquished Property (RQ, or the property she’s selling). This means Ameera must plan, leading us to Rule #5.
Rule #5: Ameera will have 45 days to identify in writing potential replacement properties in the exchange. The time requirement here provides another reason why this cannot be a seat-of-the-pants decision. Often, informed investors will want to have their potential replacement properties in mind before they sell their RQ.
The replacement properties Ameera submits must meet the following criteria:
- “The Three-Property Rule” states Ameera can replace her RQ for no more than three other properties.
- “The 200% Rule” states that Ameera can replace her RQ with properties whose collective fair market value is no more than 200% the value of her RQ.
- “The 95% Exception” allows for Ameera to use her funds to buy a property of no less than 95% of the value of her RQ.
Rule #6: Ameera may not have access to any of the exchange proceeds during the exchange period. (Remember rules 2 & 3?)
Rule #7: After the sale of her RQ, Ameera has 180 days in which to acquire the property or properties she identified in Rule #5. This is called the “Exchange Period.”
Here’s what that timeline looks like:
Do you know a good Qualified Intermediary (QI)?
Glad you asked! Title company subsidiaries can make good QIs, and Title Exchange Services, LLC (TES) serves this function as a company affiliated with True Title Company, LLC.
TES has the experience with 1031 exchanges to help you and/or your clients navigate this tricky area of the tax code. TES can sometimes even refer you to other professionals you’ll need along the way.
Of course, there’s more to this complicated real estate transaction than we were able to cover in this article. If you think you or your client may be in a position to make a 1031 Exchange, give us a call. We’ll help you get started.