As her cash flow from paradise whittled down toward pennies from heaven, Karla Guerrero's client grew increasingly disheartened.
Having inherited a rental property in Hawaii, the client counted on the steady income it offered, yet high property taxes and property management fees eroded the monthly windfall.
To resolve the issue, Guerrero, a financial planner with BOK Financial, steered the client through a 1031 exchange, which allowed the woman to defer the capital gains from the sale of the Hawaii property while acquiring two rental properties in her own state.
"In addition to eliminating the taxes and expenses tied to the rental in Hawaii, the two properties she acquired were much easier to manage," Guerrero said. "The 1031 exchange allowed her to make that adjustment."
Technically, a 1031 exchange, named after the relevant portion of the U.S. Internal Revenue Code, doesn't eliminate the tax burden on a real estate-related capital gain, but defers it into the future.
The rule applies as long as taxpayers reinvest the proceeds of their investment property into what's known as a like-kind property.
"Like-kind is very loosely applied, as the new investment property could be raw land, commercial real estate or another rental property," Guerrero said. "But it cannot be your primary residence because that's not an investment in nature."
The IRS maintains strict deadlines in the exchange process, requiring that investors:
- Identify a potential replacement property within 45 days of closing the sale of the original holding
- Conclude all related transactions within 180 days of the initial closing
"If you fail to meet any deadline, the IRS will deny the 1031 exchange," Guerrero said. "The transactions can still go through—the IRS can't stop a sale or purchase—but the capital gains won't be deferred."
Outside assistance a must
As an example, if you bought a condominium as an investment 20 years ago for $100,000 and sell it today for $200,000, a 1031 exchange may allow you to put off paying the taxes on the $100,000 gain, as long as the $200,000 is reinvested in a like-kind property.
The process requires that you hire an independent third party with no ties to you or your family. The bonded, qualified intermediary, which could be an attorney, accountant, investment broker or title company, is responsible for:
- meeting filing deadlines and requirements
- holding the proceeds from the initial sale in escrow
- dispersing the funds to the title company for the acquisition
At year-end, you receive a 1099-S form for the sale—just like when you sell any other property—and you submit a Form 8824 with your tax return.
While limited to real property assets, any commercial property is eligible for the tax-deferral move.
As for a vacation property, "it's tricky," Guerrero said. Taxpayers won't qualify if the property is mostly for personal use. A vacation home must be dedicated for rental use at fair market value for at least 14 days a year and the owner cannot use it for more than 14 days per year or 10% of the time it’s rented per year.
"And the longer it's a rental before you apply for a section 1031, the better chance you have of it sticking if the IRS challenges you," she said.
Separately, investors in more sophisticated real estate funds may also benefit from 1031 exchanges, but they must handle it through a process involving a Delaware Statutory Trust.
Potential hitches to sidestep
As the IRS doesn't take tax deferral lightly, there are some potential potholes to be aware of in the 1031 exchange process.
For example, the 180-day rule actually states that you must close on the new property within 180 days of the initial sale or your tax filing date—whichever comes first. So, if you close on a purchase late in the year and don't file for a tax extension the following spring, you could get tripped up.
"That's where many have failed to do proper planning," said Guerrero, who added that an online calendar tool can help gauge your timing. "It's crucial that you don't go it alone."
Other peculiarities of 1031 exchange rules include:
- The 14-day rental requirement on vacation properties includes the property being sold and the one being acquired if either is to qualify as an investment property.
- As long as the capital gains taxes on the initial property are deferred, the cost basis of the replacement property will be that of the original property.
- You can identify more than one replacement property, as long as you meet one of three tests: 1. You identify three potential acquisitions within 45 days; 2. You identify as many properties as you wish, but the total value doesn't exceed 200% of the property you've sold; 3. You identify as many properties as you wish, but the amount received in the sale equals at least 95% of the value of the properties you've identified.
- Backdating any documents to meet a deadline could expose you to fraud penalties by the IRS.
- If, once you close on the second property, you end up with any amount of cash, which is referred to in the industry as "boot," those proceeds are not deferred, so you must pay capital gains tax on that cash.
- Proceeds from a sale may be used to pay off an existing mortgage on the property, but if the mortgage is assumed by the buyer, that's considered boot, and subject to capital gain taxes.
- The 1031 exchange process is open to corporations as well as individuals.
In the coming months, lawmakers may explore altering or eliminating the 1031 exchange process, which President Biden proposed on the campaign trail. But with more pressing issues related to the pandemic and its repercussions, nothing is certain.
For now, however, the process remains a valuable tax-management tool to consider in your real estate transactions.