For all those tax nerds out there, they might be aware of what most of the Internal Revenue Code Sections mean. But most people never really know more than just the 401(k). Yes, the retirement package is actually named after a bit of a section from the tax code in our country.
Regardless of your overall knowledge, there is one other section from the Internal Revenue Code Sections that is becoming increasingly common nowadays: “Section 1031”. Most commonly used by realtors and investors, the term is more than just a buzzword.
What is Section 1031?
Simply stated, 1031 essentially refers to an exchange of one investment property for another. While most of the swaps that usually happen in real estate are taxable as if they were sales, if your exchange meets the requirements necessary to make it a 1031 exchange, you will either have no tax payable or a limited tax payable when you make the said exchange.
Important Facts about 1031 Exchanges You Should Know
It’s always a good idea to know more about 1031 Exchanges because they can get a little complicated. It’s better to have professional help, but if you’re just curious to know what it is, here are some of the things you probably want to know about 1031 exchanges.
1. Section 1031 Is Not for Personal Use
If you are getting the idea that you can swap your residential property with another under the Section 1031, you’d be mistaken. The provision works only for business and investment properties. There are ways that people have been trying to use Section 1031 to swap their personal vacation homes using a loophole, but that loophole is not as easy to use as it used to be.
2. Using 1031 for Your Vacation Home
You might have heard of a time where taxpayers were using 1031s to swap their vacation homes for another – even for homes that they want to go retire in. Now, the 1031 would delay the recognition of any gain and these taxpayers would move to the new home. Eventually, they will be able to use the capital gain exclusion and work wonderfully around the restrictions through this loophole.
Congress tightened this loophole, but people can still turn their vacation homes into rental properties to make 1031 exchanges. The simplest way to do it is to stop using the vacation home yourself. After that, you can rent it out to tenants for 6 months to a year and treat the tenants in a businesslike manner. This will effectively make your vacation home an investment property that you are now qualified to exchange with another investment property of around the same value.
Of course, all of this is much easier said than done. There are several intricacies that experts would be better able to inform you of.
3. Personal Property Does Not Qualify
Before amendments to the tax legislations passed in December 2017, there were some exchanges of personal property that qualified as the Section 1031 exchanges. People were able to make the like-kind swaps of aircraft, franchise licenses and equipment without the transactions being considered taxable exchanges.
Ever since the amendments were made, the law dictates that only real estate property qualifies for Section 1031 Exchanges. Partnership interests and corporate stocks did not qualify as being eligible for Section 1031 exchanges in the past and they still don’t.
Then, there is the fact that interests as a tenant in common in real estate can still qualify for a Section 1031 exchange.
4. What are Opportunity Zones?
Opportunity zones are actually a whole separate ordeal from 1031 Exchanges and for many, they present a better alternative to the Section 1031 Exchanges. You can feel free to check out details about it to learn more about what Opportunity Zones are and why they might be a better alternative to 1031 Exchanges.
5. “Like-Kind” Doesn’t Exactly Mean Like Kind
While the term like-kind exchange might make people think that this entails a certain type of property can be exchanged for exactly the same kind of property, the term actually entails a broader meaning. It is just an enigmatic phrase used for the exchange but really, the exchange can be quite varied.
You can exchange raw land for an apartment building or even a strip mall for an appropriately valued ranch. While it is called a like-kind exchange, the rules for the 1031 Exchange are pretty surprisingly liberal when it comes to making exchanges. Then again, if you are not completely aware of all the intricacies, you stand at a significant risk of getting trapped.
6. You can Go for a Delayed Exchange
Typically, the exchange is a pretty simple deal where one investment property is exchanged with another investment property of roughly the same value between two people. The thing is, the likelihood of finding someone that has the exact same property you have will be pretty unlikely. This is the reason why the majority of these Section 1031 exchanges are delayed. The delayed exchanges involve a middleman hold the cash after you “sell” the property and uses that money to “buy” the replacement property for you. This is effectively a three-way exchange, which qualifies as a swap.
7. Designating the Replacement Property is a Must
When it comes to utilizing the delayed exchanges in the Section 1031 exchange, there are two key timing rules you need to observe. The first thing you need to be considerate of is designating the replacement property. When the sale of the property happens, the intermediary (middleman) will receive the cash on your behalf. You can get absolutely no access to that cash because that will ruin the Section 1031 Exchange.
The second thing is that within 45 days of the sale, you need to designate the replacement property in writing to the intermediary. You need to let them know specifically, what property you want to acquire in exchange for yours. The Internal Revenue Service says that you can designate three properties as long as you close on one of them in 6 months.