The history of 1031 exchanges goes back to 1921. Most people in the real estate industry have heard of them and seem to have a good working grasp of how they work, and what the requirements are. Occasionally we get calls from someone who has not heard of a 1031 exchange, or has no clue what the rules are. So now would be a good time to do a refresher on the basic rules of an exchange.
IMPORTANT – Both the Old Property and the New Property must be held for investment or used in a trade or business. Many people think that if you sold a blue duplex, you must buy a blue duplex. This is not the case – you can buy any other kind of investment real estate: you could buy an apartment building, an office building, a warehouse or bare land.
People ask, “Why should I do a 1031 exchange?” I can answer this question in two words: “Financial Leveraging.” By doing a 1031 exchange, the taxes you would have paid to the government are now working to earn you money.
A 1031 exchange allows a taxpayer to postpone their long-term capital gains tax when selling an investment property by exchanging both the basis and the gain into a new investment property. This gives an investor financial leverage. If you have a property used for investment or business and you plan on buying another property used for investment or business, then yes, you need to do a 1031 exchange.
In simple terms, a 1031 exchange moves the gain from the sale of an old investment property into the purchase of a new investment property. By moving the gain into a new property, you defer paying tax on that gain into the future.
A 1031 exchange is NOT ‘a-sale-and-a-purchase,’ but an exchange of one property for another. There must be a written exchange agreement that shows that ALL the steps, from the transfer of the old property to the receipt of the new, is part of an overall plan. That plan being the 1031 exchange.
Property held for productive use in a trade, business or for investment may be exchanged for like-kind property. For real estate, like-kind property is widely defined as real property located in the United States and some of its territories. A single-family rental can be exchanged for a duplex, raw land for a shopping center, or an office building for apartments. Any combination will work.
Real property and personal property are not like-kind to one another. A commercial building may not be exchanged for an airplane, a single-family rental for a licensed timeshare, or raw land for heavy construction equipment.
What Does Not Qualify?
In 1986, the IRC 1031 was revised to exclude some property interests from being exchanged. These property interests include: a personal residence (although the portion of the residence that qualifies for business or investment use—i.e., a home office—may be exchanged), stock in trade, stocks, bonds, notes, securities or other evidence of indebtedness, partnership interests and the goodwill of a company.
Property held primarily for sale is also excluded. Examples of real property that may fall within this category include: developed lots, property held for resale, property sold immediately after acquisition or completion of improvements, speculation homes and fixer-type properties that are not rented out. Examples of non-real property include business inventory, such as cars for a car dealership or computers by a computer manufacturer.
Although IRC 1031 does not address vacation homes (or second homes), Revenue Procedure 2008-16 provides that vacation homes may qualify depending on the Exchangor’s use and tax treatment of the property.
You should understand the real estate exchange process before you go through with an improvement exchange or any other sort of exchange. This is just the exchange basics. For more information, we can introduce you to an exchange specialists.
Please contact us to discuss your situation.