Internal Revenue Code (IRC) Section 1031 covers the taxation and benefits associated with exchanging like-kind property. Real estate is a great candidate for exchanges as an asset class. Generally, when you own an appreciated asset, such as real estate, you are said to have unrealized gains. However, when you sell the asset, those gains are said to be realized by you and are recognized by the IRS (and state taxing authorities) as taxable. Essentially, Section 1031 of the IRC allows the swap of assets while deferring the capital gains tax normally associated with a sale. It can be a very powerful tool in building generational wealth because it allows you to kick the tax can down the road and grow your portfolio today when it counts most. There are even ways to eliminate capital gains through a step up in cost basis discussed later in this writing.
Like-Kind Property: What Does That Even Mean?
This section of the IRC comes with many complexities. It can only be conducted with like-kind assets. Which is good for real estate investors because it allows you to exchange undeveloped land for a rent producing building (whether residential, commercial, or industrial) or vice versa. However, the property cannot be your primary residence. The IRC states that the property must be used for the purposes of generating income by investment or through a trade or business. It can even be used on a vacation home if it meets certain criteria including, but not limited to, renting your vacation home at least 14 days a year out of at least the last two tax years.
Depreciation Recapture: Investors Beware
Another advantage of 1031 exchanges is the deferral of depreciation recapture which is taxed as ordinary income. The IRS allows you to depreciate capital assets, such as real estate, that are placed in use in a trade or business or held for investment purposes. Depreciation is the process of expensing a portion of the cost of the asset due to the normal wear and tear experienced by use.
Depreciation can be calculated using many methods; however the easiest and most common method is called straight-line depreciation. Annual depreciation expense is calculated by dividing the cost to acquire the asset and place it into service by the useful life (useful life is determined by statue). Depreciation is a paper expense. This means that you get the benefit of the expense without spending the cash. In certain circumstances, when you sell an appreciated asset that you took depreciation expenses on, a taxable event might be triggered through depreciation recapture. This is taxed as ordinary income which could be as high as 39%. A 1031 exchange allows you to not only defer the capital gains, but also the depreciation recapture. Note that if you exchange a depreciated asset (such a residential rental building) for non-depreciable property (such as undeveloped land), the depreciation recapture is triggered.
Exchange Accommodators: Don’t Touch the Money!
The code requires that there is no boot in the transaction and that the investor does not receive any of the proceeds. Let’s unpack that. Boot is excess cash that is kept by the investor after the exchange occurs. If you exchange a property with net proceeds of $500,000, you must use the full $500,000 to purchase the exchange asset. If you only use $480,000 and keep $20,000 for yourself, you will be taxed on the $20,000 at the capital gains tax rate. The funds also cannot come into your possession in an exchange. They are normally handled by an exchange accommodator (also known as an intermediary). The intermediary receives proceeds from the sale and disburses them to the purchase escrow, so you never touch the money. This is another requirement for a successful transaction. As you are beginning to see, this is not something investors should venture alone.
The 45-Day Rule & the 180-Day Rule: Another Layer of Complexity
There are also timing considerations with 1031 exchanges. There are two timing rules to abide by to successfully execute the exchange to receive the preferential tax treatment. The first is the 45-Day Rule and it states that within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property you want to acquire. Often investors will identify three target properties in case one or two of them don’t work out. The 180-Day Rule requires you to close on one of your identified properties within 180 days of the sale of your old property. These timelines are not staggered. This means that both clocks start ticking the day you sell your old property. So if you identify your new property 20 days after you sell your old property, you only have 160 days to close on your new property. This part can be tricky and the recommendation here is to run both transactions through the same broker. By using the same broker handling the sale of your old property to also handle the purchase of your new property, you are minimizing the risk associated with delays due to communication inefficiencies.
Primary Residence: Can I use 1031 Exchanges?
This is a no go per IRC section 1031. The code states that the property must be held for investment purposes or be placed in service in a trade or business to qualify for 1031 treatment. As such, your primary residence does not qualify. The good news is as a homeowner you are allowed to exclude up to $500,000 for married couples ($250,000 for single individuals) of capital gains from being taxed when you sell your home. You can take this exclusion if you have lived in your home for any two of the last five years. If you sell your primary residence and have lived there for many years, you likely have capital gains as your property has likely appreciated over the years. What do you do if you and your spouse purchased your home for $400,000 and today it is worth $1,800,000? The capital gains on your home would be $1,400,000 and you can only exclude $500,000. This leaves you with $900,000 of capital gains which, depending on your tax bracket, could be taxed at 20%.
Section 1031 states that if a property has been used in a trade or business for the two most recent tax years, it qualifies for deferral of capital gains. So in this case it might be worthwhile to rent your home out for two years before selling it as you would get the exclusion for $500,000 and be able to defer the capital gains tax on the remaining $900,000.
What if you need the money sitting in your home’s equity today and can’t wait two years to take advantage of the $500,000 exclusion? Getting a cash out refinance is a non-taxable event. This allows you to access some of the equity in your home while still maintaining the integrity of the 1031 exchange deferral and the homeowner’s exclusion.
Where Does it End?!
At this point you might be wondering if you can keep exchanging and keep deferring the capital gains along with depreciation recapture. Yes, there is no limit to the number or frequency of exchanges. However, this creates a bit of a tax snowball that keeps growing every time you exchange. The solution to this problem is found under the current tax code in something called a step-up in cost basis. Capital gains are calculated by taking the difference between sale proceeds and adjusted basis of the property. If the sale proceeds are greater than the adjusted basis, a capital gain exists. The IRS allows for a step up in basis for inherited property. What this does is on the day the property is inherited the adjusted basis becomes the fair market value of the property. This step up also eliminates the depreciation recapture that has accumulated with each exchange. I believe the spirit of this section of the code is set so that if a property needs to be liquidated upon inheritance the person receiving the property isn’t left with a mountain of a tax bill. For instance, if you buy a $400,000 property bequeath it to your heirs when it is worth $2,000,000, they will have no capital gains on it. However, if you sell it before they inherit it and just give them the proceeds, you will first have to pay capital gains tax on $1,600,000.
The Bottom Line
There are many benefits to 1031 exchanges. Savvy investors can use this tool to grow wealth much quicker than if they were to not take advantage of this section of the IRC. As double edge swords normally go, this does not come without its complexities and nuances. Having a team of experts like Buckingham Investments work with your tax and legal professionals is crucial to a successful real estate investing journey. Only your tax professional knows your specific financial situation so please consult with them about your unique circumstances.
*Please consult a tax professional for any and all tax advice*