The Basics of Like-Kind (1031) Exchanges
By Sallie Paris
After graduating from Louisiana State University, I returned home to Alabama and began a career in banking. I quickly discovered that my bank clients considered their real estate holdings to be integral to healthy financial portfolios.
As a Coastal Luxury agent, my goal is to offer clients a broad level of service, not only by helping them find the perfect properties, but also by helping them make informed, appropriate financial choices through our firm’s network of expert contractors and advisors. Because the real estate market on 30A continues to grow (with sales over $1.2 billion in 2016), people flock to our beautiful area to invest.
Often, owners sell one property only to reinvest in another. Some elect to use Like-Kind Exchanges to defer gains and defer and potentially reduce tax liabilities. Like-Kind Exchanges are governed by Internal Revenue Code Section 1031. Thus, they are commonly referred to as “1031 Exchanges.”
It is important that home-buyers understand how to time, structure, and calculate transactions under 1031 Code, which can be confusing. Investors considering a like-kind exchange should consult a tax advisor or certified financial planner. As a realtor, I cannot give tax or financial planning advice, but I can help clients understand the basics of 1031 Exchanges from my perspective and experience as a buyers agent. I also researched a variety of sources for current information. Each is listed at the bottom of this article.
Like-Kind Exchange defined:
Internal Revenue Service, Code 1031:
Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.
Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.
Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality.
A layman’s definition, according to Forbes.com
contributor Robert W. Wood:
…a 1031 exchange … is a swap of one business or investment asset for another…. Although most swaps are taxable as sales, if you come within 1031, you’ll either have no tax or limited tax due at the time of the exchange.
Typical Reasons to Utilize a Like-kind Exchange:
- Use property instead of loans or cash to finance a new investment.
- Trade an old property for a newer, more valuable property.
- Defer capital gains taxes.
- Consolidate multiple rental properties into one.
- Diversify investments by exchanging one property for multiple properties.
- Investments grow tax-deferred as you roll over gains from one property into another and accumulate appreciation.
- Investors potentially avoid paying taxes until they sell property for cash.
- At the final liquidation, property owners can take advantage of the lower capital gains rate associated with long-term investments.
Deadlines and Parameters:
Within 45 days of closing on the property an owner is selling, the owner must file a list of a minimum of three replacement properties. Sellers file that list with a third-party exchange facilitator (see below).
Within 180 days of the original transaction, the investor must close on a replacement property. The equity transferred from the original property to the replacement property must be equal to or more than the equity in the original to defer captain gains taxes.
It is not required for those who reinvest to reinvest all equity from the original property into the replacement property. If one chooses to take some cash from the transaction or reinvest in a property of lesser value, he/she will pay capital gains taxes in the same tax year as the exchange, but only on the cash received.
Important Things to Remember:
Buyers must retain an exchange facilitator, also known as a qualified intermediary, to administer the transaction. Facilitators prevent property owners from taking constructive receipt (ownership) of funds, which is critical to complying with IRS Code.
Only certain types of properties fall under IRS Code 1031. Some properties may be considered stock in trade if they are only purchased/built/flipped for quick resale. Primary residences may not be considered for 1031 Exchanges, but there are exceptions.
Vacation homes may be considered but must meet specific qualifications.
Coastal Luxury agents, certified public accounts, and attorneys can direct you to exchange facilitators.
Sallie Paris is a real estate agent at Coastal Luxury, and specializes in representing buyers. With a broad local market knowledge and a high level of service, she assists clients in all aspects of real estate purchases—from investment properties to beach homes. Sallie says, “Although I’ve lived here for years, I still feel like I’m on vacation every day. My goal is to help other families find the perfect property so they can grow to love the Emerald Coast as much as I do.”
Contact Sallie at 850.213.3478 or Sallie@CoastalLuxury.com
Link to the IRS Form 8824: www.irs.gov/pub/irs-pdf/f8824.pdf