About 5 years ago, I was purchasing a property that had a few disclosures I had not heard of or come across before. The disclosures were for the seller of the property notifying me that the sale of the building was part of a “1031 Like-Kind exchange“. I was immediately curious, so I started researching and began conversations with more experienced landlords. This is the main point: the program is used to take the proceeds from the sale of one property and apply them to a new property, tax free. It is used often by the wealthily and lawyer-equipped, but not enough by the average landlord.
In time, I got a full picture of the program. There are a large number of caveats, requirements, and loop holes. Many of which I will go into here.
- The program carries forward any capital gains or losses so that they are not recognized at the time of the transition.
- The properties must be “like kind”, meaning that the property that is being sold and the property being purchased must be used for the same purpose. Primary residences and vacation homes are excluded from the “like-kind” definition and therefore, the program becomes only applicable to rental and commercial business properties.
- There is a loop-hole here. If someone did want to use the program for the sale of a primary or vacation home, all that needs to be done is to rent out the home for two years and then the program can be applied. In addition, the property should be recorded on tax returns under schedule E as an income property.
- The rules surrounding the “like-kind” can be confusing because while they are strict surrounding the exchange of primer residences and vacations homes, they can be a lot less particular about the kind of business property. For instance, in many cases, a building could be exchanged for land or vise versa.
- “Like-kind” also means that the property should be within the 50 United States and not on foreign territory. There is some discussion on the possibility of U.S. territories being included.
- The section can also be used for other types of properties; some examples include livestock or paintings. There are more specific limitations here, however.
- Once someone has sold the property, they have 45 days to find the new property and 180 days to acquire it.
- Holidays do not extend the period.
- The new investment must be of equal or greater value.
- Liabilities must also be considered. If the mortgage acquired on the new property is less than the mortgage on the property sold, the lower liability will be taxed as cash. For example, if one property was sold for $300,000.00 with a mortgage of $150,000.00, but the buyer used $50,000.00 in cash along with the $150,000 in equity to purchase a new building for $300,000, the total amount down would be $200,000.00, requiring a mortgage of only $100,000.00. The decrease in liability of $50,000.00 would be taxed as income. This is definitely something to avoid.
- To use the program to exchange one property for another, someone would need to use a “qualified intermediary” to hold the funds (wired at the time of closing) until the purchase of the exchanged property.
- There are limitations on the number of properties that can be purchased as a result of the exchange. Say for instance that you had $150,000.00 in equity from the sale of one property. You could split the $150,000.00 as a downpayment on up to three different properties.
- There are limitations on the amount that the purchase price of the new property can exceed the old; no more than 200%. If you were selling a building for $300,000.00, the new property being purchased could not exceed a purchase price of $900,000.00.
- The IRS is strict about their policy surrounding the identification periods. Extensions are rarely granted. The cause of the failures around many exchanges is this particular stipulation.
The key thing to note is this, you can expand your holdings without recognizing the capital gains until a much later date. Say, for example, that you have a $300,000.00 investment property with 50% equity. You have $150,000.00 you can pull out of the building in that instance. Instead of selling it and paying the 25% capital gains, which would be $37,500.00, you can take the full $150,000.00 and use it as a downpayment on a larger building with higher cash flow and principal accumulation. If you could find a loan with 20% down, you could theoretically buy a building for the price of $750,000.00 for the sale of your $300,000.00 building. You can save thousands in taxes and simultaneously increase your gross holdings substantially. In the examples above, gross assets would be increased by 150%.
There are a number of other benefits included in this as well. If you needed to carry forward a loss from the sale in one year to an income heavy tax year, you can do that as well.
In any case, it is probably a good idea to consult an experienced company when conducting this kind of exchange. There are multiple ways in which an investor could end up paying taxes. Take the example from above, if you purchased a new property that required a lower down payment than the proceeds from the sale, you could end up pocketing cash at closing, and having to pay taxes on that income. Though not in the code, this is often referred to as a “Boot”.
The section of the tax code can be confusing and does have quite a lot of particulars. However, when used properly, it can extremely beneficial. Just like a 401K account, an investor would be able to defer the taxes and grow their investments.
Let me know if I left anything out!