1031 Exchange
The third in a three-part series
By Jefferson Riddell, Esq
After the real estate downturn, the number of 1031 exchanges [1] decreased significantly. However, lately we’ve noticed an uptick in 1031 exchanges, perhaps a sign that the market is recovering or just an indication that investors are realizing it’s still one of the best tax shelters available.
You may remember the tax shelters of the 1970s and 1980s–horses, equipment, real estate limited partnerships, oil and gas, the list goes on and on. The IRS didn’t like them, characterized many of them as abusive, required “tax matters partners” to identify themselves so it would be easier to go after people, and generally tried to put them out of business. Because of this attack, including tax law changes in the early 1980s about use of passive losses, we have few tax shelters left.
We do have the Section 121 exemption for the sale of your main home ($250,000 capital gains exemption for a single homeowner, $500,000 for a married couple), if you live in the house as your main home for two out of the last five years. And we still have the 1031 Exchange.
The concept is simple. You enter into an exchange agreement with a Qualified Intermediary (QI), then sell your investment, rental or business property (supposedly not including personal use property which is property you live in as your main home, vacation home, etc.). You escrow the proceeds with the QI, locate replacement property, close on it within 45 days, and if you haven’t closed on it within 45 days but have just identified it, you close within 180 days or the due date of your tax return for the year of sale of the relinquished property. You can have more than one relinquished property and more than one replacement property in a single 1031 exchange, but the 45- and 180-day deadlines run from the date of sale of the first relinquished property.
There are variations on the theme such as reverse exchanges and construction exchanges, but we won’t go into that here. 1031 exchanges are referred to by different names such as Starker exchanges, tax-free exchanges, deferred exchanges, 1031 exchanges and “like-kind” exchanges, but all of these mean the same thing. “Like kind,” contrary to some people’s belief that you cannot exchange, for instance, vacant land for a rental condominium, simply means any real estate for real estate, other than personal use properties. Bottom line: if you follow the rules and accomplish the exchange by trading even or up in value, you pay no capital gains tax.
But the tax is not forgiven, only deferred. Well, you say, what good is that? The good is that you get to keep using the money as if you have a free loan from Uncle Sam, and you may avoid the tax entirely if a couple of things happen to occur. Under the current version of our federal estate tax law, if you die owning the last of a series of 1031 exchange properties, your heirs receive a stepped-up basis to fair market value and the tax is wiped out.
Also, if you should happen to buy a nice house or condo as a replacement property, rent it for a while (no one knows for sure what is a safe “for a while”) and then change your mind about being a landlord, move in, make it your main home, satisfy the “two out of the last five years” rule and sell it more than five years after you buy it, a married couple can wipe out up to $500,000 of accumulated capital gain under the current rules (Section 121).
This article is for information purposes only and does not constitute legal advice.
Click HERE [2] to read Part 2
Jeff Riddell is a Sarasota, Florida attorney specializing in 1031 Exchanges. He holds a real estate broker’s license, has published numerous articles on real estate transactions and most recently authored a book on titled 21st Century Real Estate Investing. U.S. 1031 Exchange Services [3], 3400 S. Tamiami Trail, Sarasota, FL 34239. Telephone: (877) 455-2628. Website: www.us1031.com [4]
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