While gearing up for the busy year-end transaction season, here are a few of the topics we get asked about the most.
1. The Term Like-Kind
2. Sell One, Buy One
3. Reinvest Everything
4. Replacing Debt
5. Exchange a Vacation Home
The Term Like-Kind
“I am selling an office building so I have to look for replacement property that is an office building because of the “like-kind” requirement, right?”
This is by far the question we get asked the most. For real property transactions (rental houses, farmland, office buildings, strip malls, etc.) the “like-kind” requirement does not mean selling and buying the exact same type of property. 1031 Exchanges are often called “like-kind exchanges” because that is the language used in the tax code. The IRS is actually very broad scoped in the case of real property like-kindness. The regulations state that “all real property is like-kind to all real property”. Therefore, if you are selling a real property interest (anything that you have fee title to) you can look for any kind of real property as a replacement property. For example, you can sell farmland and purchase a single family rental residence or sell a rental condominium and purchase a whole or partial interest in an apartment building. This allows an investor to greatly diversify a real estate portfolio. The regulations for personal property (non-real property items such as airplanes, machinery, business vehicles, artwork, etc.) are far more restrictive, so please contact us to discuss specific requirements for a personal property transaction. Personal property exchanges were eliminated with the Tax Cut and Jobs Act that was signed into law on December 22, 2017, and took effect on January 1, 2018. Read about the impact the Tax Cut and Jobs Act had on Sec. 1031 here.
Sell One, Buy One
“I am selling one property, so I have to buy just one property, right?”
Not at all. The IRS looks at the overall value of the property or properties to determine whether you have satisfied the exchange value requirement. In other words, you can sell one property and exchange into multiple replacement properties or the other way around. You can sell multiple properties and exchange into one larger and more easily managed property. You can buy or sell any number of properties in an exchange. This is particularly helpful if you are needing to cross state lines as property values in some areas of the country are far different than in other parts. Again, this allows an investor to diversify or change directions in accordance with life changes (a move, retirement planning, etc.). The devil is in the details however. Coordinating multiple property closings within the 45 and 180 day time frames can be tricky! Make sure you choose a reputable Qualified Intermediary, like IPX1031®, to help you with the specific needs of your exchange.
“I must reinvest all of the funds from the sale of the relinquished property.”
Only if you planning on deferring 100% of your taxes. A 1031 Exchange is not an “all or nothing” proposition. No gain, no taxes, but if you do have a gain, then you will be taxed on that gain. Keep in mind everyone’s circumstances are different. Say you don’t want to pay a large tax bill at tax time but you need some of your proceeds to pay off other obligations. Or you find the ideal replacement property but it is a little lower value than the relinquished property. This is the time to consider a partial exchange. This defer some, pay some method is ideal for some investors and companies but you need to consult with your tax advisor to determine the amount of tax that will be due. Read more.
“I must replace the debt that I had on the relinquished property with at least the same amount of debt on the replacement property.”
Well, not exactly. In order to defer all your taxes, the IRS really wants you to do two things: 1) buy equal or greater in value to the property sold and 2) don’t walk away with any cash or debt relief. The taxpayer can always bring in money out of pocket to avoid the worry of debt replacement. However, if you are getting a loan, you want to avoid the loan overfunding at closing to result in a boot situation. Very often, at close of escrow the loan value will be figured in and then the QI funds requested. If this leaves any proceeds in the account, this will result in a boot situation because now the taxpayer has cash in hand. Make sure you are working with all parties to assure this does not happen to you. Read more.
Exchange a Vacation Home
“I can exchange my vacation home in the mountains, right?”
If you are staying in your vacation home more than two weeks out of the year or more than 10% of the time you rent it, then no, you cannot exchange it. Vacation homes or other homes utilized by family members not paying fair market rent do NOT qualify for 1031 tax deferral, nor will you be able to use the personal residence exclusion. You will pay your taxes upon the relinquishment. A fair amount of tax planning should be done in anticipation of any “vacation” home. Please contact your tax professional to discuss this sometimes tricky structure as it may require long term planning to 1031 out of it. Read more.
For further misconceptions, please take a look at more misconceptions we previously published.