Your business is changing, and so are your real estate needs. Maybe the office building you own is too small with the growth in employees? Or maybe you own multifamily housing units and want to change your investment strategy to commercial real estate? So how do you make these investments and keep the equity out of Uncle Sam’s Pocket? Maybe a 1031 exchange can help.
WHAT IS A 1031 EXCHANGE?
A 1031 exchange is a tax deferment strategy that can be used by investors in commercial and residential real estate. In brief, it allows investors to defer federal income taxes on the sale of a property if the sale proceeds are used to purchase another property.
WHY SHOULD I CARE?
You will keep more of your money! By deferring federal income taxes generated from the sale of your property, you will be able to roll all your equity into a replacement property. If you sell property outside of an exchange, it is highly probable that Uncle Sam will want a share of the proceeds. Bottom line, if you own investment or commercial use property, you need to know about 1031 exchanges.
WHAT ELSE DO I NEED TO KNOW?
As with any tax-saving strategy, there are many rules that come into play. The basics are summarized below. Please note that there are many considerations not included in this article.
- Both the property you sell and the property you buy as a replacement must be qualified property. In the past, taxpayers could use 1031 exchanges for vehicles and equipment, but that changed with the 2017 Tax Cuts and Jobs Act. Currently, only “real property” (IRS term) qualifies. Real property includes real estate of all kinds: land, houses, apartments, commercial buildings, etc. Mineral interests may also qualify in some circumstances.
- The property you sell and the replacement property you buy DO NOT have to be identical. For example, you can exchange land for a commercial building, or a commercial building for a rental house.
- Both the property you sell and the property you buy must be held for investment or commercial use. Your personal home will not qualify under most circumstances (multi-family housing or homes on acreage are possible exceptions). Property that is being flipped or built for sale will not qualify under most circumstances.
- It is possible to go through a 1031 exchange and defer only a portion of the taxes. In order to completely defer taxes, the following conditions must be met:
- Cash: All proceeds from the sale must be transferred to a 1031 intermediary (discussed below) and subsequently used to purchase a qualifying replacement property.
- Replacement property: The value of the replacement property must be greater than the fair market value of the property sold.
- Debt: If debt was associated with the sale property, debt of the same amount or greater must be associated with the replacement property.
- To summarize: trade up, not down, don’t pay down debt, and don’t take cash out at closing.
- If a non-qualifying property is included in the transaction, some of the tax may not be deferred. For example, if you exchange a ranch for an apartment complex, there may be vehicles or equipment included in the sale of the ranch that are not qualifying property. As a result, a tax may be incurred on the portion of the sale proceeds attributable to the vehicles and equipment.
- The property you sell and the property you buy must be held by the same taxable entity. For example, you can own both properties in your personal name, or in a company you own. You cannot sell a property owned by Company A and then purchase the replacement property in Company B, unless Company B is a disregarded entity owned by Company A.
- There are time limits that must be followed:
- 45-Day Identification Window: After you close on the sale of your property, you have 45 days to identify the replacement property.
- 180-Day Purchase Window: After you close on the sale of your property, you have 180 days to close on the replacement property.
- Important Note: Filing your tax return can cut this window short. Make sure that your tax professional is aware that you are working on a 1031 exchange and that your return may need to be extended.
WHO CAN HELP ME WITH THIS?
In order to complete a 1031 exchange, you must work with a qualified intermediary to hold the proceeds of the initial sale until you close on a replacement property. There are quite a few companies that offer this service; just do an internet search for “1031 broker.” Many of these companies can also assist you with finding replacement proper-ties or offer other value-added services.
It would also be prudent to communicate early and often with your tax professional in order to make sure that you complete a transaction that qualifies as a 1031 exchange, and that the exchange is reported properly to the IRS. Please feel free to call ADKF at 210-829-1300. We are here to help!
ADKF is the largest, locally owned public accounting firm in San Antonio, Texas, with branch offices in Boerne and New Braunfels. We have been serving our community since 1991. We are a full-service CPA firm dedicated to providing a broad range of tax, audit, bookkeeping, tax controversy, and consulting services with superior customer service to help our clients meet their goals and objectives. Please click here to set an appointment with us.