Property exchange is a legal alternative to the regular purchase and sale of property which usually provides the taxpayer or property owner with an income tax break. The proceeds from the sale of a property are subject to taxation by the U.S. government. However, an exchange “trading” one property for another eliminates any taxable gains from the transaction.
Some of the most common concepts involved in property exchange include:
- 1031 Exchange. A 1031 exchange allows a taxpayer to exchange a current property for a similar replacement property. Because the money involved in a 1031 exchange passes through the hands of a qualified intermediary, and all proceeds from the sale of the first property are invested in the replacement property, there are no taxable gains.
- Like-Kind Exchange. A like-kind exchange is the same thing as a 1031 exchange. Like-kind exchanges refer to the exchange of similar types of property, or “like-kind” property. For example, exchanging one building (real property) for another building (also real property) is a like-kind exchange.
- Boot. “Boot” or “boot received” refers to taxable property or gain received as the result of a 1031 exchange.
What Is Section 1031?
A 1031 exchange is a swap of one investment property for another. Most swaps are taxable as sales, but if your swap meets the requirements of 1031, you’ll have no tax or limited tax due at the time of exchange.
You can change the form of your investment, as the IRS sees it, without recognizing a capital gain, allowing your investment to continue to grow tax-deferred. There’s no limit on how frequently you can do 1031 exchanges. You can rollover the gain from one investment property to another, and another, and another, many times over. Although you may earn a profit on each swap, you avoid paying tax until you sell the property for cash. At that point, you’ll pay only one tax at a long-term capital gains rate. Capital gains rates are currently 15% or 20%, depending on income, and 0% for some lower-income taxpayers.
Most exchanges must be of like-kind. “Like-kind” is just a phrase. The property doesn’t have to be similar. You can exchange an apartment for undeveloped land or a farm for a strip mall. The rules are enforced liberally. You can exchange one business for another. However, the 1031 provision is for investment and business property. Although the rules can apply to a former residence under certain conditions, and there are also ways to use 1031 for swapping vacation homes, the loopholes are narrow.
What Are the Rules for Depreciable Property?
Special rules apply when depreciable property is exchanged via Section 1031. These rules can trigger a profit known as depreciation recapture. Depreciation recapture is taxed as ordinary income. Typically, you can avoid depreciation recapture if you swap one building for another building. If you exchange improved land with a building for unimproved land without a building, then the depreciation that you’ve previously claimed on the building will be recaptured as ordinary income.
Consider hiring a real estate lawyer when you’re doing 1031 exchanges to avoid complications.
What Are the Changes to the Section 1031 Rules?
Before the Tax Cuts and Jobs Act (TCJA) was passed in December 2017, some exchanges of personal property—such as franchise licenses, aircraft, and equipment—qualified for a 1031 exchange. Now, only real property or real estate as defined in Section 1031 qualifies for an exchange. The TCJA has a full expensing allowance for certain personal property that may help to make up for this change to tax law.
The TCJA includes a transition rule that permitted a 1031 exchange of qualified personal property in 2018 if the original property was sold or the replacement property was acquired by Dec. 31, 2017. The transition rule is specific to the taxpayer. The rule does not permit a reverse 1031 exchange where the new property was purchased before the old property is sold.
What Are the Important 1031 Exchange Timelines and Rules?
Exchanges involve a swap of one property for another between two people. However, the likelihood of finding someone with the exact property that you want who wants the exact property that you have is slim. Most exchanges are delayed or three-party exchanges. In a delayed exchange, you must use a qualified intermediary, who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. This three-party exchange is treated as a swap.
There are two key timelines that you must observe during delayed exchanges:
- 45-day rule: This rule relates to the designation of a replacement property. Once the sale of your property occurs, an intermediary will receive the cash. You cannot receive the cash directly under a 1031 exchange. Within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary and specify the property that you wish to acquire. The IRS says you can designate three properties as long as you close on one of them. If they fall within specific valuation tests, you may designate more than three properties.
- 180-day rule: You must close on a new property within 180 days of the sale of the old property. The two time periods run concurrently, meaning the clock starts ticking when the sale of your property closes. If you designate a replacement property exactly 50 days later, you’ll have 130 days left to close on it.
It’s possible to buy a replacement property before selling the old one and still qualify for a 1031 exchange. In this case, the 45 and 180-day time windows apply.
To qualify for a reverse exchange, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and complete the transaction within 180 days after the replacement property was bought.
Can I Use a 1031 Exchange for Vacation Homes?
Taxpayers used to use the 1031 provision to swap one vacation home for another. Taxpayers could use this exchange for a house where they want to retire, and Section 1031 would delay any recognition of gain. Taxpayers could move into their new property, make it their primary residence, and eventually use the $500,000 capital gain exclusion. This exclusion allowed taxpayers to sell their primary residence and, combined with their spouse, shield $500,000 in capital gain, as long as they’d lived there for two years out of the past five.
In 2004, Congress tightened that loophole. However, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Per the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.
Do I Need a Real Estate Lawyer for My Property Exchange Issue?
Real estate lawyers can help you determine whether or not your property is qualified, whether or not you can file for a 1031 exchange, and how to avoid receiving boot as a result of such an exchange. If you are unfairly taxed for an exchange or penalized for failing to pay a tax resulting from a property exchange, you may require a lawyer to represent you before the IRS. Use LegalMatch to find a real estate lawyer in your area today.