Learn about the tax benefits of this property-swap tax loophole for investors.
Real estate is a sound investment for a few reasons. Real estate tends to increase in value over time, and owning a property that you operate as a rental can be a great passive income stream. And for some, it can offer tax benefits. One of these is frequently referred to as the 1031 exchange.
In general, while short-term capital gains are taxed at regular income rates, long-term capital gains, which apply to properties held for more than a year before being sold, tend to max out at a flat 15% or 20%, which is beneficial for many investors who are in this business for the long haul.
But what if you could avoid paying capital gains tax from real estate transactions?
This is the basic premise behind 1031 exchanges, which are so named for the provision in the Internal Revenue Code that allows investors/rental property owners to, in essence, swap one property for another while the profits from a sale are held by a legally sanctioned third party in an escrow account, where it stays until the money is reinvested in a new property. Because the seller never actually realizes the financial gain, they are not responsible for capital gains tax — at least, not unless they eventually sell the same property directly.
For those who earn passive income as landlords, this can be a financially advantageous strategy. It’s a nice little loophole that encourages investment to stimulate the economy, and if done correctly, there is no limit to the amount of times it can be done. But it involves a set of stringent requirements for anyone who wants to try taking advantage of it.
We have had several investors reach out to our CPA firm asking for our tax expertise in this area, so this month’s blog will address some of the basics and how we can help.
Here are the basic rules around 1031 exchanges:
First and foremost, a 1031 exchange is only legally allowed for residential and commercial rental/investment properties, not personal residences. And it should not be done on the property that was a personal residence less than a year ago (our recommendation is that it should have been rented at least two years before attempting a 1031).
Additionally, the properties you’re exchanging must be in the United States and used only for business or investment purposes. In other words, they must be “like kind” properties. You can’t swap an apartment building for a house you plan to live in, for instance.
However, the rules around what’s considered “like kind” are fairly loose; you could, as an example, swap an apartment building for a plot of empty land or an office building. You can also do an exchange for multiple properties — for example, using the sale of a strip mall to buy a couple apartment buildings. The new property/properties could also be of higher or lesser value than the one you sold.
Other restrictions include timing — you only have 45 days between the sale of your original, or relinquished, property and the selection of the replacement property. You are allowed to identify more than one property, and then close on the one you’ve selected within 180 days after the date of the sale of the relinquished property.
But most importantly, the funds derived from the sale of the original property must be held by a Qualified Intermediary, sometimes known as an Exchange Facilitator. These specialized financial experts are legally authorized to serve as third-party fiduciaries who hold money or assets obtained through property sales that are engaged in 1031 exchange scenarios. They are specially trained, credentialed agents who ensure that all the IRS rules pertaining to 1031 exchanges are followed and deadlines met, for the benefit of all parties involved. This way, the transaction stays clean, enabling a swap rather than a sale that makes way for the inherent tax benefits.
Some folks, including you (the seller), your attorney, your tax advisor, your family members, your employer, and others affiliated with you, are prohibited from serving as intermediaries. (To find Qualified Intermediaries in your state, start by visiting www.1031.org.)
The process can be repeated as frequently as you like; as long as you never receive or touch the proceeds of the sale of relinquished properties, you can avoid paying capital gains indefinitely… until you either sell the property and finally take the money, or until you die. (And when that happens, your heir pays no capital gains.) As you can see, for specific individuals, this can be a very advantageous arrangement.
Tax Implications
This is where you need a good, knowledgeable CPA. While the Qualified Intermediary addresses the legal compliance with Section 1031, a CPA who has expertise in these exchanges is an important ally.
Not only does a CPA know how to report the exchange on a tax return, calculating the deferred gain, but they continue to do this as often as the exchanges take place. Each time, the tax basis must be re-adjusted to account for exchange expenses, fees, and sometimes apportioned to multiple exchange properties. As you can guess, this would affect your rental properties’ depreciation schedules quite a bit.
Finally, each state has its own rules regarding 1031 exchange reporting, and a CPA who is knowledgeable about 1031 exchanges will know how to comply with your particular state’s tax laws. For example, California has what’s called a “claw back provision” that requires you to report the 1031 exchange indefinitely — even if no further exchanges take place — until it is either sold or you die. And if you sell it, California will ask for its share of the tax on cap gains, even if you moved out of the state a long time ago. Other states with similar requirements include Virginia, Massachusetts, Montana, and Oregon.
For all of this, you need a CPA who has experience handling all the nuances of 1031 exchanges to ensure there are no tax compliance errors, who understands the varying laws in multiple states. That’s a tall order, but it’s one we at Ludmila CPA can handle.
Our team at Ludmila CPA loves talking to clients about 1031 exchanges and their tax implications, and our expertise in multistate compliance means it doesn’t matter where you’re located or where the transaction is taking place — we can still help! Contact us to set up your tax planning appointment today!