A 1031 exchange helps investors at tax time

A world of tax rules awaits investors when it comes to selling properties. But sticking to the basics of one popular tool to maximize profits and avoid capital gains taxes has proved to be one of the best bets for building foundational real estate wealth.

It is called a 1031 exchange. And it is a tax-deferring transaction that can be used in just about any property portfolio.

What is a 1031 exchange?

A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows an investor to avoid paying capital gains taxes on the sale of an investment property, as long the proceeds are reinvested within certain time limits in a property or properties of equal or greater value.

1031 Exchange rules and regulations

• It is a swap of properties that are held for business or investment purposes. (Houses that are flipped do not qualify.)
• The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred.
• If used correctly, there is no limit on how many times or how frequently an investor can execute a 1031 exchange.
• The rules can apply to a former primary residence under very specific conditions.

Several requirements must still be met, but the process becomes less daunting with a qualified agent managing the escrow and sale.

History and politics of the ‘like-kind’ exchange

The 1031 exchange, also referred to as like-kind exchange, has been in the tax code since 1921 and has undergone tweaks under various administrations in the last century. The Trump administration’s Tax Cut and Jobs Act, passed in December of 2017, excluded certain personal property and intangible property, limiting 1031 exchanges to real estate property.

As of Jan. 1, 2018, the IRS reported, “exchanges of personal or intangible property such as machinery, equipment, vehicles, artwork, collectibles, patents, and other intellectual property generally do not qualify for nonrecognition of gain or loss as like-kind exchanges.”

Requirements to qualify for the tax break

Investors also must buy a property or properties of equal or greater value. So, if a duplex sold for $1 million, the other rental property must cost at least $1 million, or if buying multiple properties, they need to add up to $1 million or more.

It is also necessary to exchange one rental for another rental. An investor cannot use the 1031 exchange to sell a home and then buy a piece of land that isn't attached to income. And she cannot sell a rental home and then use the 1031 exchange to buy a vacation home.

The qualified intermediary, who holds the escrow exchange fund, plays a key role in this process. If an investor touch any of the money made when she sold a property, she will immediately be subject to paying taxes. Spending the money or moving it into an investor’s account would incur penalties; such actions void the 1031 exchange.

Beware of the 1031 exchange trap  

Investors should be wary of being trapped in a long cycle of numerous 1031 Exchange transactions. If an investor sells a property for a gain, then did an exchange, sold the next property, and did another exchange, and so on, large capital gains can be realized. After 10 or 15 years, deferred gains could lead to a large tax liability as the final property is wound down, possibly locking in deferred depreciation recapture and capital gains tax.

A section 121 exclusion can save even more

Thanks to Section 121 of the Internal Revenue Code, the taxpayer is entitled to a $250,000 (if single) or $500,000 (if married filing jointly) exclusion on the sale of any property they own and have used as a primary residence (also known as a “principal residence”) for twenty-four out of the last 60 months. With an exclusion, it is not necessary to pay taxes or reinvest. These 24 months also do not have to be spent consecutively.

Like a 1031 Exchange, it is prudent to consult with a real estate professional before performing a Section 121 Exclusion to make sure it is done correctly.

There are several ways in which the 1031 exchange and a Section 121 exclusion can complement one another. Here is an example.

• An investor buys a property and lives in it for two years. Then she moves out and converts it into a rental.

• The property is kept as an investment for 18 months.

• When the rental property is sold, an investor can use the Section 121 Exclusion and the tax deferrals from the 1031 Exchange.

121 Exclusion and 1031 exchange with allocation

An investor can also combine a 121 Exclusion with a 1031 Exchange when a portion of a business property serves as a primary residence.

For example, an investor owns a four-unit rental property, lives in one and rents out the three others. The investor can still use the 121 Exclusion and 1031 Exchange as outlined above, except the part used as a principal residence would need to be “allocated” when performing the 1031 Exchange.

When performing the 1031 Exchange, the investor will allocate the principal residence part and apply the Section 121 exclusion toward the proceeds from that part rather than the whole complex, which means that only the income from the principal residence portion will be eligible for the Section 121 Exclusion. The three remaining units’ income would go toward the 1031 Exchange's new property.