February 2024 – 1031 Exchanges
1031 EXCHANGES
OVERVIEW
As we navigate the ever-changing landscape of real estate, we wanted to provide a refresher on 1031 Exchanges and some details on how they can also be used for vacation rentals.
A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows real estate owners to defer capital gains taxes on the sale of qualifying real estate properties. By reinvesting the proceeds from the sale into a similar property or properties, property owners can postpone the tax liability and potentially enhance their overall real estate ownership.
WHO QUALIFIES FOR A 1031 EXCHANGE?
– Owners of investment and business property may qualify to engage in 1031 exchanges. This includes individuals, C corporations, S corporations, Partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity.
–Types of property that are permitted to engage in a 1031 exchange include the following: residential, commercial, agriculture, conservation easements, oil/gas/mineral/water rights, and tenants in common trusts.
WHAT ARE THE RULES & CONSIDERATIONS?
– It MUST be an exchange. A sale of property and subsequent purchase of another property does not count as a 1031 exchange.
– The properties exchanged MUST be like-kind. Like-kind property is property that is similar enough to be in the same property class.
– We recommend always using a qualified intermediary to guide and execute the compliance work, ensuring you are in-scope and following the 1031 exchange rules. Keep in mind that while qualified intermediaries are not required in an exchange between just two parties, an intermediary is required for exchanges involving any more than two parties.
– Depending on transaction specifics, cash, debt relief, or non-like-kind property received in the exchange may trigger a recognizable gain.
– There are strict time limits that MUST be met during the exchange. First, the seller must identify a potential property to purchase within 45 days of selling their property being exchanged. Second, the property purchased must be received and the exchange completed no later than 180 days after the sale of the exchanged property.
– Beware of taking control of cash or other proceeds before the exchange is complete. Doing so may completely disqualify the transaction from being a 1031 exchange, making the transaction immediately taxable. This is why we recommend working with a qualified intermediary who can assist and protect the nature of your 1031 exchange.
– How to find a qualified intermediary: please either consult with real estate agents you trust, or consult this search engine to find a qualified intermediary.
1031 EXCHANGES FOR VACATION HOMES
– At this time in the market, vacation homes are likely saleable for a much higher price than they were purchased at. If the sales price greatly exceeds the original cost and the owner has rented their vacation home out to others more than they have used it personally, this could generate a large gain if the owner decides to sell.
– In the above scenario, it would be more tax-advantageous to be able to engage in a 1031 exchange by swapping one vacation home for another vacation home, therefore deferring the large gain that would ensue if the owner simply sold their vacation home.
– To engage in a 1031 exchange by swapping one vacation home for another, a few additional considerations are necessary:
– The property relinquished must have been owned by the taxpayer for at least 24 months immediately before the exchange.
– Within each of the two 12-month periods within the 24-month period prior to the exchange, the property must have been rented out for 14 days or more and the taxpayer’s personal use of the property cannot have exceeded the greater of 14 days or 10% of the days the property was rented out at market rates. This essentially ensures the property had more business use than personal use, as personal use property is not eligible for 1031 exchanges.
– The property received must continue to be owned by the taxpayer for at least 24 months immediately following the exchange.
– Within each of the two 12-month periods within the 24-month period following the exchange, the property must have been rented out for 14 days or more and the taxpayer’s personal use of the property cannot have exceeded the greater of 14 days or 10% of the market days. Again, this ensures business use on both sides of the transaction as personal use property is not eligible for 1031 exchange treatment.
ADDITIONAL RESOURCES
A 1031 exchange is a powerful strategy that, when executed correctly, can help postpone gains on property sales. By reinvesting the proceeds from property sales into a similar property, or properties, property owners can defer the tax liability within legal compliance and potentially enhance their overall real estate ownership.
If you have any questions or if you’re interested in exploring the potential of a 1031 exchange, please feel free to review this 1031 Manual and/or reach out to us and we will be happy to assist you.