The 1031 exchange has been a part of the US tax code since 1921. It is widely used, inexpensive and not complicated. Thousands of investors, large and small, use it daily. The gain can be deferred as long as a replacement property is purchased within 180 days. Potential properties must be identified within 45 days if a purchase has not been completed.
Investors, realtors, closing agents, etc., sometimes confuse the “kind” of property being exchanged.
According to the IRS, there are three “kinds” of property:
- Personal Residence- A single property used as the principle residence of an investor.
- Inventory- This is property built for sale or property purchased and rehabbed for sale.
- Investment Property- This can be any type of real estate: commercial, multi-family, residential, agricultural, air rights, oil and gas royalties, mineral rights, easements, condos, and any other estate in real estate.
When an investor sells a property with high equity, they often use the proceeds to buy two properties. They continue this process, enlarging their portfolio and maintaining leverage. Another advantage is that they can change the type of property they invest in and/ or the location. The relinquished property must be owned for a year to qualify as a capital asset eligible for long-term capital gains. There is no minimum holding period for replacement property, as long as the investment intent is provable. A tenant is generally required, not just advertising or listing for sale. A lease option tenant could be put in a replacement property and with some help, qualify for a loan in 4 to 6 months. A 1031 exchange is then possible. No minimum holding time is available on future properties.
Title holding entities can be a factor in exchanges. Partnerships generally require that the partnership purchases the replacement properties. The partnership then does a distribution to the members, and they can do as they wish in the future. Partners cannot decide that some can take cash and some can take properties. Corporations and multi-member LLCs must purchase properties in the same entity that sold the property. Single member LLC’s, investors, and trusts can interchange those entities at will since the investor is the taxpayer in all cases. Multiple owners in a land trust can individually decide whether to take cash or real estate. They are treated as tenants-in-common and can do as they choose.
If an investor has a duplex or multi-unit and resides in one of the units, they can do a combination code section 121 tax-free sale of a residence and a code section 1031 sale of an investment property. One closing statement can be used, dividing the percentage of property used as a home from the investment portion. A residence can be changed to an investment property by renting it and holding for required. And then a tax-free exchange is allowable. Conversely, an investment property can be changed to a personal residence. The tax code defines the holding periods required for these transactions.
Over the long history of 1031 exchanges, there have been many hundreds of court cases, private letter rulings, tax memorandums, and other decisions paving the way for more creative exchanges. Historically, the IRS objects to a procedure and it goes to Tax Court. The courts have often ruled that if there are not definitive guidelines, the taxpayer wins and the IRS is instructed to write a clear revision to the Tax Court. This has happened with holding period disagreements, reverse exchanges, buy and build transactions, and more. The process for exchanging options tax-free has come into question but has been allowed, contrary to the opinion of many practitioners. If an investor holds an option for more than a year, he is allowed to exchange it, tax-free, for other options or for real estate.
In summary, 1031 tax-free exchange is a special benefit to real estate investors. It is not available to stock market investors. Exchangers can continuously defer taxes and upon death, the property is passed to heirs at a stepped-up basis and the tax never is paid. It can be an important part of your success in real estate.
Written by: Jack Shea