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The 1031 Exchange

Date: 7/1/2017

Author: Real Estate Hotline


A like-kind exchange generally applies to real estate and was designed for people who wanted to exchange properties of equal value.

If you own land in Oregon and trade it for a shopping center in Rhode Island, if the values of the two properties are equal, you don’t pay capital gains tax even if both properties may have appreciated since they were originally purchased.

1031 exchange transactions don’t have to involve identical types of investment properties, they just must be of “like-kind.” For example, you can swap an apartment building for a shopping center, or a piece of undeveloped, raw land for an office or building. You can even swap a second home that you rent out for a parking lot.

There is no limit to how many times you can use a Section 1031 exchange. You can roll over the gain from your investment swaps for many years but, that gain is deferred, not forgiven. So you must keep track of your basis in the new property you acquired in the exchange. Section 1031 is not for personal use. For example, you can’t use it for stocks, bonds, and other securities, or personal property (with limited exceptions such as artwork).

When considering a Section 1031 exchange, it’s important to consider mortgage loans and other debt on the property you are planning to swap. Let’s say you hold a $200,000 mortgage on your existing property, but your “new” property only holds a mortgage of $150,000. Even if you’re not receiving cash from the trade, your mortgage liability has decreased by $50,000. In the eyes of the IRS, this is classified as “boot, “ and you will still be liable for capital gains tax because it is still treated as “gain.”

A Section 1031 transaction requires planning in advance. You must identify your replacement property within 45 days of selling your estate. Then you must close on that within 180 days. There is no grace period. If your closing gets delayed by a storm or by other unforeseen circumstances, and you cannot close in time, you’re back to a taxable sale.

Find an escrow agent that specializes in these types of transactions and contact your accountant to set up the IRS form ahead of time. Some people just sell their property, take cash and put it in their bank account. They figure that all they must do is find a new property within 45 days and close within 180 days. But that’s not the case. As soon as “sellers” have cash in their hands, or the paperwork isn’t done right, they’ve lost their opportunity to use this provision of the code.

Section 1031 exchanges may be used for swapping vacation homes, but present a trickier situation. Here’s an example of how this might work. Let’s say you stop going to your condo at the ski resort and instead rent it out to a bona fide tenant for 12 months. In doing so, you’ve effectively converted the condo to an investment property, which you can then swap for another property under the Section 1031 exchange.

However, if you want to use your new property as a vacation home, there’s a catch. You’ll need to comply with a 2008 IRS safe harbor rule that states in each of the 12-month periods following the 1031 exchange you must rent the dwelling to someone for 14 days (or more) consecutively. In addition, you cannot use the dwelling more than the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented out for at fair rental price.

You must report a section 1031 exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred. If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.

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