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Section 1031  Real Estate Exchanges

Section 1031 real estate exchanges provide that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business, or for investment, so long as the property is exchanged for like-kind property.   All investment real estate qualifies under this provision.

Property Which Does Not Qualify For A 1031 Exchange includes –

A personal residence
Land under development for resale
Construction or fix/flips for resale
Property purchased for resale
Inventory property
Corporation common stock
Bonds
Notes
Partnership interests

A tax deferred exchange allows an investor to sell a piece of investment property (i.e. rental), trade or business , and buy a new property with the gain or profit from the sale, and not owe taxes on the sale immediately. If you eventually sell the new piece of property, you would owe taxes at that time. Generally, all gains and losses on sales of real estate are taxable, but an exception lies where the property sold is traded or exchanged for "like-kind" property. The new property is seen as a continuation of the original investment, so taxes are not due at the time of the sale.

And because it is a rental property, you get to deduct all the expenses related to running the property. These include taxes, interest, insurance, repairs, utilities, supplies, cleaning, maintenance and any commissions you pay (to leasing agents and the like). You can also deduct any mileage  per mile you incur going to keep an eye on the property.  Make sure the cash flow from the rental property is positive -- otherwise the property will turn into an alligator. 

You also get to depreciate the cost of the property. You depreciate the building, not the land. Apply the percentage allocation on your real estate tax bill between land and improvements to find your depreciable basis. If 85% of the assessment is for improvements, 85% of your total cost for the property, including any capitalized closing costs (e.g. title insurance, legal fees etc.) is allowed as a deduction, spread over 27.5 years.

Remember, this depreciation expense allowed on your tax return (Schedule E) is based on the total cost, not what you put down. If you buy a $120,000 rental property and only put down 20% ($24,000), your depreciation is based on the whole cost-$120,000. If 85% of your property-tax bill is allocated to improvements, assuming $2,000 in closing costs, your yearly deduction for depreciation is $3,771 (Add $120,000 and $2,000, multiply the sum by .85 and that result by .03636.) If you're in the 30% bracket, you save $1,131 in taxes. In the 27% bracket, the savings are come to $1,018.

Remember, this depreciation expense is a pencil transaction. While you're taking a tax deduction for the "depreciation" of your property, it's actually appreciating in value! (At least, that's the hope.)

Assume you bought this $120,000 property. After several years, it's now worth $200,000. If you've taken $40,000 in depreciation, your basis is reduced to $82,000. (Your original $120,000 plus $2,000 in closing costs less $40,000 in depreciation.) If you sold now, you'd have a taxable gain of $118,000. That's $200,000 less your basis of $82,000.  But if you reinvested the $200,000 in another rental property, you'd defer any tax. 

There are important rules to follow for the deal to qualify as a 1031 tax-free exchange: You must identify the new property within 45 days of the closing of the old, and settle the new deal within 180 days.   You also can't touch the money except for the purchase of the new property. It must be held by a qualified third-party intermediary like an escrow company. That's a person or entity that's not controlled or beholden to you. There are lots of companies that do this professionally, but you could just as easily use a non-related friend.  Ignoring closing costs, you should now have at least $104,000 in equity cash. That's the $24,000 you originally put up plus the $80,000 in real appreciation. With that much cash, and a 20% down payment, you can now buy a new rental property for as much as $520,000. (20% of $520,000 is $104,000.)

Every time you sell, reinvest under Section 1031. All of your gains are tax-deferred -- not excluded. At some point, the time will come when you have to pay the tax bill. 

How long do you have to rent it? While the code is silent, the IRS has validated a rental period of as little as two years. 

There is a special rule for exchanges between related parties which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years after the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two-year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs.

Often, a taxpayer will sell to a related party but receive replacement property from an unrelated party. Tax and Exchange Professionals do not perceive this type of transaction to be a "related party exchange" and this is okay.

Also, a taxpayer will often desire to sell to an unrelated party and receive replacement property from a related party. This type of related party transaction does not work according to the IRS if the related party receives cash.  The IRS reasons that if the taxpayer or a related party “cashes out” of property in this manner, IRC §1031(f)(4) “kicks-in” and the exchange is disallowed.

However, if the related party is also doing an exchange (and is not “cashing out”) then it is okay to receive replacement property from a related party according to PLR 2004-40002.  This is technically not a “related party exchange” because it is not a reciprocal deed-swap, and therefore, the two-year ownership requirement should not apply.  However, some commentators believe that it might.  The law is unclear on this issue.  

Related parties under the rules are the following -

  • Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.);

  • An individual and a corporation when the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;

  • Two corporations that are members of the same controlled group as defined in §1563(a), except that "more than 50%" is substituted for "at least 80%" in that definition;

  • A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;

  • A grantor and fiduciary, and the fiduciary and beneficiary, of any trust;

  • Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts;

  • A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such an organization, or a member of that person's family;

  • A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership;

  • Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;

  • Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or

  • An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.

  • Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or

  • A person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.

A disqualifying disposition does not include dispositions by reason of the death of either party, the compulsory or involuntary conversion of the exchanged property if the exchange occurred before the threat or imminence of the conversion, or dispositions where it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as one of their principal purposes the avoidance of federal income tax.

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