Rental properties have many great benefits including favorable tax benefits with the IRS. Not only can you depreciate rental properties to save on taxes, but a 1031 exchange allows you to sell a rental properties and defer the taxes on any profit you make or recaptured depreciation. A 1031 exchange has many rules and regulations and you have to make sure you complete the exchange correctly to avoid a large tax bill from the IRS. I am not an accountant or an attorney, please consult your attorney or accountant for any specific tax or legal advice.
What is a 1031 exchange and how does it work?
A 1031 exchange is a real estate transaction that involves two like properties; one being sold and one being bought within a certain time frame. There are many restrictions on a 1031 exchange and the IRS is not perfectly clear when describing the restrictions. Some basic principles are the properties must be held at least a year, be used for business, the replacement property must be identified in 45 days and bought in 180 days. If all of these requirements are met and a few others, a rental property can be sold without paying any taxes on the profit or recaptured depreciation.
What taxes would be owed without a 1031 exchange?
When you sell a rental property, you have to pay taxes on any profit you make on the property. You also may have to pay recaptured depreciation on a rental property. The IRS allows you to depreciate a rental property because they feel the structure has a limited life span and decreases in value every year. You can deduct that depreciated amount from your taxes every year, which is a huge bonus to owning rental properties. However, if you sell the rental property for more than what the depreciated value is, you will have to pay back those taxes you saved. Here is an example:
- Property is bought for $100,000 and the structure is worth $90,000.
- Over ten years over $32,000 can be depreciated from the home. That money can be deducted from your income on your taxes.
- If you sell the house for $100,000, the $32,000 would come back and show as income on your taxes.
If you have owned a rental property for several years, the recaptured depreciation can add up to a lot of taxes. Luckily the 1031 exchange lets you move the profit and recaptured depreciation into another similar property without paying taxes.
A rental property is usually on a 27.5 year depreciation schedule; after the 27.5 years the property becomes completely depreciated. When you complete a 1031 exchange, you can sell the depreciated property without paying taxes and buy a new property but you still have the same depreciation schedule.
What properties can be used in a 1031 exchange?
The IRS has determined that many forms of real estate can be used for a 1031 exchange including any property used for a business which includes a store, manufacturing facility or office building. Investment property can also be used for a 1031 exchange, which includes rental properties. It has even been determined that water rights and mineral rights qualify for a 1031 exchange. These cannot be used for a 1031 exchange:
Stock in trade or other property held primarily for sale
Stocks, bonds, or notes
Other securities or evidences of indebtedness or interest
Interests in a partnership (we will discuss later a major exception to this one)
Certificates of trust or beneficial interests
A Chose in action (a right to something, such as payment of a debt or damages for injury, that can be recovered in a lawsuit)
Can fix and flips be used in a 1031 exchange?
The IRS has determined fix and flips cannot be use for a 1031 exchange, unless you meet certain guidelines. The IRS does not want real estate investors who fix and flip constantly to be able to use a 1031 exchange to defer taxes. If you only fix and flip occasionally and meet these guidelines you may be able to use a 1031 exchange.
1. The flip must be rented out for at least one year after it is repaired.
2. The home cannot be sold until after it has been rented at least one year and should not be listed before being rented for a year.
The problem with this strategy is the IRS does not say you have to hold a flip one year to do an exchange. The IRS simply says a flip list shall be held for an acceptable amount of time, and it is up to the accountant and investor to determine if their transaction qualifies. Some people have determined that to be a year, but if the IRS thinks you are a professional house flipper trying to cheat them out of money, you still may get in trouble.
How do you complete a 1031 exchange?
When completing a 1031 exchange a qualified intermediary must be used by the investor to oversee that transaction. The IRS does not tell you who can be an intermediary, only that these people cannot be one:
The TP’s attorney
The TP’s CPA
The TP’s real estate agent
Any relative of the TP
Any employee of the TP
Any business associate of the TP
The intermediary holds the funds after one property is sold in the 1031 exchange and uses that money to buy the new replacement property. When doing a 1031 exchange, the owner must identify the property he is exchanging and declare it before the sale. Once the subject property is sold, the investor has 45 days to identify a new property to exchange with the old property. Once the new property is identified the investor has 180 days to close on the new property.
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How is the money handled with a 1031 exchange?
When selling a property and buying a new property in a 1031 exchange, the investor must use all the cash from the sale of his property to buy the new property to avoid paying taxes. The new property must cost at least as much as the sale price of the old property to avoid paying taxes as well. If the investor does not use all the cash from the sale of his old property or buys a cheaper property, he may have to pay taxes on the unused cash or price difference in the properties.
The reason the investor has to buy a property that is just as expensive as the property he sold is because liabilities must be considered. If you sell a house for $200,000 that has a $100,000 loan and exchange it into a $100,000 house, you still had gain. You used all of the cash from the first sale to buy the second house, but you also had $100,000 of debt that was paid off. That paid off debt can be considered a gain.
How does an investor take title when doing a 1031 exchange?
When doing a 1031 exchange, the investor must take title to the new property in the same name as he owned the property being replaced.
You also cannot use a 1031 exchange to sell property to someone you are related to.
What is a Reverse 1031 exchange?
Most investors will sell a property they own and then purchase a replacement property. It is possible to buy the replacement property and then sell your original property. This can be a difficult maneuver because the investor will not have the cash from the sale of his original property to buy the new property.
It may make sense for an investor who is building a replacement property to exchange into it. It may take more time to build and buy a property than 180 days, and that is why an investor would do a reverse exchange. This is appropriate for large companies exchanging manufacturing facilities or other unique buildings that must be built to spec and are not available on the market.
Can you refinance a property after doing a 1031 exchange?
One way to get the cash out of a rental property you exchange into is to refinance the replacement property. You may have $100,000 in cash proceeds from a rental property you are exchanging. That money can used to buy a replacement property in a 1031 exchange, but that is a lot of money to have locked up. If you refinance the property after buying it, you can take out some of that cash without paying taxes on it. The government does not consider money from a refinance profit.
How can you completely defer taxes on a 1031 exchange using a personal residence?
It is also possible to complete a 1031 exchange into a personal residence and then eliminate the taxes altogether. Exchange a property into a house that you would like to live in at some point. The replacement house must be rented for at least a year after the exchange is completed. Once that year is up, move into the replacement house and live there for at least two years. Since you are living in the home for at least 2 out of 5 years as a personal residence when you sell the house, your profit is tax free! There are some restrictions to this and please talk to your accountant!
There are a lot of intricacies and details in the IRS tax code that must be adhered to when completing a 1031 exchange. There are more types of 1031 exchanges and many more situations that investors will run into. Talk to an accountant or attorney to make sure you are following all the guidelines. For more information on my investing strategy, check out my complete guide to purchasing long-term rental properties.