01 Jul The 1031 Exchange Primer
Margaret A.M. Heine
is the principal counsel at Heine Law Group in Fullerton, California. She is licensed in California and Washington and has authority to practice before the Supreme Court of the United States and the United States Court of International Trade.
THE 1031 EXCHANGE PRIMER
The real estate market continues to grow, and that means that some people have made money on the real estate market. Even that modest home you purchased a few years ago has increased in value. The upward spiral in the real estate market has attracted more and more investors, and now with some sell offs happening before the elections, investors are looking to preserve their cash by selling current investments and reinvesting in new investments. One vehicle that increasingly more investors are looking at is the 1031 exchange.
The 1031 exchange is governed by the Internal Revenue Code § 1031. It allows an investor the opportunity to defer paying capital gains on the sale of the investment if you reinvest the funds into a similar or like investment. This is not a tax free transaction it simply defers the tax on the gain until a later time. When the property is sold for the last time, there are a number of tax calculations which will take place including a repayment of 25% of the depreciation you have written off on the investment.
This is different from straight investment because both transactions take place in a prescribed period of time, and the investor does not get to take the proceeds of the property being exchanged. An accommodator or qualified intermediary is required to hold the proceeds from the first sale to put directly into the acquisition. Most sales contracts will designate that the sale is a 1031 exchange as there are strict timelines which must be met to have a valid exchange and complete the deferment of tax.
Properties in an exchange generally need to be identified within 45 days of the original sale, and the new transaction completed within 180 days of the original sale.
“Like kind” property means that you can exchange any real property for real property, even if it has a different character. For example, you could exchange an apartment building for a ranch, or commercial building for an apartment complex. The Tax Cuts and Jobs Act which took effect on January 1, 2018 eliminate the 1031 exchange for business assets like machinery, fixtures, equipment and vehicles, but most importantly, cannot be used for FCC license, liquor licenses, distribution rights, or business assets which frequently have a high business value, but are not real property. The general purpose of the exchange is for property which is for business or investment purposes. It does not apply to your personal residence or a second home normally. Under the 1031 exchange rules, the property will need to be in the United States.
The target property to be purchased must be greater or equal in value to the property being sold. So, if you are selling a 1,000,000 property (net), then the new property must be at least 1,000,000 in order qualify for a full deferral of the taxes. In essence, you take the sale price of the property being exchanged and the new property must be valued at least that amount plus cost of acquisition of the property like broker costs.
If you purchase a replacement property of lesser value, you would then pay capital gains on the difference in value between the two properties so that the carry forward tax deferral is only on the gain which would have occurred had you paid taxes on the sale.
Generally speaking, it must be the same person selling (the person claiming the exemption) and the same person purchasing the investment property. The named persons would be the same on both titles to the properties.
It is important to keep in mind that in the future, if the value of the replacement property falls, you will still be responsible for the gains which would have been recognized at the first sale—even though it is more money than you are currently recovering from the sale. So, the replacement property should not be overvalued if there is a risk of the value of the property not being sustained.
The replacement property does not need to be in the same state or location as the property being sold. So, you could sell Texas property and buy California property, or sell California property and buy Montana property—but, California has a recapture program in place so that when the out of state property is sold, you have to file a California tax return so that California recoups the deferred taxes you received as a result of the California property being sold.
The 1031 exchange will defer the capital gain which is payable on the transaction as well as the Medicare Tax capture on the sale of the property and the recapture of depreciation previously discussed. It is possible under the law currently that upon the death of the owner, the 1031 exchange values will be stepped up to the date of death valuation, and thereby, all capital gains would be valued from the date of death until the date of sale; so, the heirs may not pay any capital gains. This would be, of course, subject to the current estate tax exemption amounts in effect at the time.
Be cautious if you are planning a 1031 exchange outside of California as not all states recognize the 1031 exemption or have stringent requirements that the exchanges must all take place within their state. That will not affect your federal exemption, but could result in your paying state capital gains taxes on the transaction. There are also other states, like California, that have some requirements if you are a non-resident or become a non-resident for the exchange, including, Colorado, New York, North Carolina, Virginia, Delaware and Hawaii to name a few.
It is advisable to have a CPA or tax advisor who is knowledgeable about the 1031 exchange laws and any changes in the law which may be coming up.
Remember, you must declare the 1031 exchange and have very specific time frames in which to identify and complete the transaction. You must use an intermediary to protect the benefits of the exchange.