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Who is Eligible
for A 1031 Exchange?
The appeal of 1031 exchanges is obvious to savvy investors: the ability to defer, or even (by virtue of savvy estate planning) eliminate capital gains taxes, is a powerful financial incentive to consider an exchange. So let’s delve into the eligibility requirements for a 1031 exchange.
Requirement #1: The first requirement seems simple enough: to be eligible for a 1031 exchange, you must be a real estate investor, in possession of an appreciated piece of real property.
Let’s start with the simplest word: you.
For the purposes of a 1031 exchange, “you” can certainly be an individual investor. But you can also be a partnership (general or limited), a corporation (“C” or “S”), a trust, a limited liability company (LLC), or virtually any other tax-paying entity. In short, if you can own investment real estate and pay taxes on it, you can structure a 1031 exchange when selling the property in question.
Requirement #2: Both properties in the exchange—the one being sold, and the one being acquired—need to be investment real estate.
That’s another important IRS requirement: we’re talking about investment real estate here. So while individual investors are eligible, they can’t structure a 1031 exchange based on a desire to sell their primary residence or even a vacation home, and shield themselves from capital gains by investing the proceeds into a piece of investment property. Both properties in the exchange—the one being sold, and the one being acquired—need to be investment real estate. Section 1031 of the code makes it clear that properties held for use in a trade or business also qualify as investment properties for the purposes of an exchange.
A caveat: some folks have found a workaround in the case of second homes, or vacation homes, by transforming them into investment properties by renting them out for a period of time before selling them. A 2007 Tax Court case determined that properties held for personal use, even with the hope or expectation of capital gains, did not qualify as investments if the investor used them exclusively for their own use, or for the use of family or friends. A subsequent 2008 revenue procedure clarified that real properties qualified for 1031 exchanges if they were held by the investor for at least 24 months prior to (or subsequent to) the exchange, and for each of the two 12-month periods, they were rented at fair market value for at least 14 days, while restricting personal use to 14 days OR 10% of the number of days it was rented at fair market value, whichever was greater.
Requirement #3: The property being sold, or relinquished, must be an appreciated piece of real estate.
Finally, since the goal of a 1031 exchange is the deferral of capital gains tax by the investor, it stands to reason that the property being sold, or relinquished, must be an appreciated piece of real estate. As such, under ordinary circumstances, its sale would generally trigger a capital gains tax. If you’re somehow holding a piece of investment real estate whose sale would post a loss instead of a gain, there’s no need to consider a 1031 exchange, or any other investment technique designed at minimizing taxes. That’s the sole upside of a bad real estate investment: the tax man has no interest in your transaction!
Requirement #4: You must reinvest the proceeds into a like-kind exchange.
Assuming your real estate investment follows the pattern of the lion’s share of such transactions, and is subject to capital gains tax upon sale, the final requirement is your willingness as an investor to reinvest the proceeds into a like-kind exchange. In other words, you must sell your piece of investment real estate and subsequently buy another, usually more valuable, piece of real property that will also be an investment property.
Requirement #5: You must avoid a common pitfall to keep the tax man away.
If not properly structured, only a portion of a 1031 exchange might qualify for the deferral or elimination of capital gains taxes. Sometimes the replacement property is valued at a lower price than the relinquished property; the resulting difference between the two prices, known as boot, would present the investor with a tax bill based on the amount of the difference. (Learn more about Boot in Lesson 1 of Master the 1031 Exchange.)
Another common example of boot occurs when there is an unpaid mortgage on the relinquished property, but not on the replacement property. IRS regulations consider any debt the investor is relieved of as a result of the transaction to be money received. So if the investor sells the relinquished property and pays off mortgage debt with sale proceeds, the IRS would likely see this as a taxable gain to the investor and tax it accordingly. The easiest way to avoid mortgage boot is to encumber the replacement property with the same amount of debt as the relinquished property had on it.
There are other ways in which 1031 exchanges may result in boot, and several options to mitigate the situation, all of which merit a full discussion in a future chapter. For now, it’s enough to take note that actually paying the tax bill in question is a last resort, and one that can usually be avoided.
Requirement #6: You must follow strict timelines.
Ultimately, if you are ready, willing, and able to follow the timelines and other requirements proscribed by Section 1031 of the Internal Revenue Code, both your sale and your subsequent purchase will qualify for the preferential tax treatment of your resulting capital gains. We’ll examine these timelines and requirements in great detail in subsequent chapters of this guide, as we do in our 1031 Exchange Masterclass.
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