What is a 1031 Exchange?
There is a loophole in the laws related to selling real estate that is listed under Section 1031 of the tax code. This law allows you to trade a property for another piece of property of equal or greater value without recognizing a taxable gain. There is a provision in this law that allows you to sell your property for cash, then defer the gain by using a qualified intermediary to hold the funds from the sale in the interim while replacement property is being purchased. This is very valuable as a way to reinvest gains on a property tax-free.
Who benefits most from this?
High income earners who are already in high tax brackets and may be pushed into the top brackets and Alternative Minimum Tax benefit greatly from deferring gains on real estate. This also can be used when selling properties that have not met the one year holding period to qualify for capital gains in order to not pay ordinary income on the gains. Also if you have a highly depreciated property there can be a large recapture of depreciation amounts taxed at higher rates and this can be worthwhile to defer.
What are the drawbacks?
Capital gains rates have been at all time lows in the last decade and are just starting to creep up. Still, many taxpayers will find themselves in zero percent capital gains brackets now- meaning there is no tax on the sale anyways. For 2014 this is true if you are a married couple earning less than $73,800 or a single taxpayer earning less than $36,900.
Can you give an example?
Let's say you live in a low cost part of the country and sell a property for $100,000 that you bought for $60,000 and put an additional $20,000 into remodeling. The $20,000 worth of gain will be tax free for a couple in this situation if they earn around $50,000 a year in income. While this does not help many in more expensive parts of the country, for those who are lucky enough to live in a reasonable area, or for gains taken in a year with little other income, paying the capital gains tax can be smarter than delaying the tax to a future year.
How does a 1031 Exchange work?
You contract with a qualified intermediary (QI) before you have accepted an offer on your current property for sale. All monies paid for the sale must be handled by the QI and you are not allowed to accept any funds personally. In order for the exchange to be valid the property exchanged for must be of greater value, and if not owned free and clear there must be additional debt taken out, such as a larger new loan. If any excess proceeds are received by you they will be taxed as "boot". Properties must be identified within 45 days after sale, and the replacement property must be purchased within 180 days.
Can this be used on my primary residence or vacation home?
Unfortunately, no. Your primary residence has one of the best tax loopholes available for it, with the homeowner's exclusion allowing you to exclude up to $500,000 in gains. However, if you have depreciated your home for business purposes you may be subject to recapture of that depreciation when sold. If you are worried about a large recapture and wish to sell your home as part of a 1031 exchange, we would recommend that you rent it out for a minimum of one year, with a legitimate renter and income, not just listing it available for rent. After that time period it would then clearly qualify for the exchange.