Real estate investment can involve multiple sales and purchases of properties. Ordinarily, when a property owner sells and realizes a profit, he or she will owe taxes on the capital gain. However, when an investor uses a 1031 exchange, taxes on the capital gain can be delayed or deferred. Understanding 1031 exchanges for commercial real estate can give investors the freedom to buy and sell investment properties while minimizing their tax liability. Here is a brief overview of the basics of a 1031 exchange.
What is a 1031 Exchange?
IRS code Section 1031 allows property owners to exchange one investment property for another. When the requirements are met, the owner will owe few if any taxes which would ordinarily be due upon the sale or trade of property. As a commercial investor, you are essentially changing your investment’s form without realizing any gain.
What are the 1031 Rules?
Under the recent tax law changes, 1031 exchanges now only apply to real estate. Further, they are only allowed for investment properties, which means trading one personal residence for the other will not be a qualifying transaction. The IRS does not limit the number of times you can do a 1031 exchange. Although you may profit from each exchange, this process allows you to defer paying taxes until you finally sell. Ideally, you will be able to make your final sale under the preferential long-term capital gains rate.
How Does a 1031 Work?
Once a property is sold, a designated intermediary will be given the proceeds rather than the owner. This is important because if the owner receives the funds directly, they cannot complete a 1031 transaction. The owner has 45 days after the sale to identify the replacement property and notify the intermediary in writing. The IRS permits owners to designate up to three properties as long as at least one is closed on. The property closing must take place within 180 days of the sale. Any excess capital which is leftover after the replacement sale will be paid to the property owner and can be taxed as capital gain.
Vacation Properties and Personal Residences
At one time, taxpayers were able to use 1031 exchanges to trade one vacation home for another and later move into the property and use certain primary residence capital gains exclusions. However, in 2004, the law was changed to put more constraints on this type of transaction. Now, vacation properties which are used for investment can qualify provided they are used for business purposes for a considerable amount of time. In other words, now an owner cannot exchange a property and immediately make it his or her residence and use the capital gains exclusion.
Those looking to move into their 1031 exchanged residence, may be able to do so provided they meet the IRS safe harbor rule. To meet the rule, during each of the two years after the exchange, you must rent the unit for fair market value for at least 14 days and your personal use cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented.
1031 exchanges can be an excellent way for commercial property investors to continue acquiring property while deferring capital gains taxes. However, these are complicated transactions, and it is vital that you consult with a qualified real estate attorney in order to ensure that you comply with the rules and realize the maximum benefits.
At Rabideau Klein, we have expertise in handling multi-million-dollar transactions for high-end real estate in the Palm Beach area. Guy Rabideau, Esq. and David E. Klein, Esq. are Florida Board-Certified Real Estate Attorneys with extensive experience with 1031 exchanges. We have the expertise and local knowledge you need to ensure that your real estate exchange complies with the law and is in your best interests. Contact Rabideau Klein today to discuss your real estate legal needs.