Section 26 of the US Tax Code, a.k.a. the IRS federal tax code, is about 75,000 pages long. Out of those 75,000 pages, one section is so popular that it is known by number alone: code section 1031. You may have heard of a section 1031 exchange but, unless you invest in real estate, I bet you haven’t read it. That’s ok because I’m going to explain why the IRS codified this information and, more importantly, why you need to know about it.
Code section 1031 allows an investor to exchange investment or business property he owns for “like kind” property in order to defer paying taxes on what would have otherwise been a taxable sale. Basically, you are trading a property you own for a similarly-valued, “like kind” piece of property. As originally intended by Congress, a like-kind exchange is easily transacted, since it’s unlikely that you’re going to be able to a) find another person with a similarly-valued piece of property and b) convince him to trade his property for yours. Be aware that, because an exchange must take place, each party to a 1031 must avoid an outright sale and purchase.
What typically happens is that you hire a Qualified Intermediary, or “QI”, to effect an exchange between you and another person who has “like-kind”, similarly-valued property. This is referred to as a “Starker” exchange – named, as you might guess, for the first bold citizen who tried this tactic and beat the IRS in court.
In a Starker exchange, the QI holds the proceeds from your sale and uses it to buy your “exchange” property. If you take control of the proceeds at any point in the process, you void the exchange and will owe taxes as with any sale of appreciated property. This is the most misunderstood area of 1031’s – I can’t tell you how many people have told me they have sold property and need to “roll it into” another property so they won’t have to pay taxes on it! Sorry, Charlie – by that time, it’s too late.
Some other points you need to know about a Starker exchange are:
- You cannot use your CPA or attorney as a QI if they have provided services for you in the past two years.
- You must designate replacement property, in writing, to the QI within 45 days of the property sale. In order for the replacement property to be considered valid, you must meet one of these three criteria:
- You choose up to three replacement properties as long as you close on one of them,
- You choose an unlimited number of replacement properties as long as the total FMV (Fair Market Value) doesn’t exceed 200% of the value of the property you are trading, or
- You choose an unlimited number of replacement properties as long as you receive at least 95% of the FMV of all properties before the end of the exchange period.
- You must close on the new property within six months.
- Any cash, or “boot” you receive in addition to the property is taxable.
Depending upon the complexity of the exchange, you can expect to pay $3,000 to $5,000+ to the QI for her role in the transactions.
Here are some other tips that may help you plan for future 1031 exchanges:
- Personal property (such as your home) does not qualify for a tax-deferred exchange.
- You can exchange one property for multiple properties.
- Like-kind has a very liberal definition. You can exchange raw land for an apartment building, for example.
- Other property, such as investment artwork, can qualify for an exchange.
- You may be able to exchange a vacation home by converting it into a rental property, but you have to go further than calling it a rental property. Actually renting it out for six months (better, a year) will help cement your position.
- You cannot exchange corporate stock or partnership interests but you can exchange businesses!
- If you leave the exchanged property to your heirs at death, they get a stepped-up basis, permanently avoiding taxation.
Do you own real estate? If so, how can you insulate your net worth from damages if something goes awry? Michelle has some pointers for you in her vlog, Protect Your Assets!