Section 1031 exchanges allow for individuals to sell qualifying properties without having to pay any federal income taxes, which are commonly referred to as “1031 exchanges” or “like-kind exchanges”. This article helps to identify how to properly take advantage of this rule to defer capital gains taxation until gains have been realized.
Before continuing into this article, there are two important terms you should know. “Relinquished property” will refer to the property being sold that you wish to defer capital gains taxation on, and “replacement property” refers to the property you intend to purchase with funds from the relinquished property. “Individual” will refer to the party engaged in the 1031 exchange.
Section 1031 exchanges allow for an individual to reinvest proceeds from the exchange of property held for productive use in a trade or business or for investment. This must be exchanged for real property of “like-kind”. The rules also require that this is a true exchange meaning that the individual is not engaged in dealer activity when buying and selling properties. Here, we want to avoid any appearance that the individual might be buying houses and flipping them regularly.
Dealers and Flipping Houses
Flipping houses for a profit will result in the classification as a “dealer”, who do not qualify for the 1031 exchange tax deferral treatment. The logic here is that dealers hold property as inventory instead of as an investment property. This classification may be avoided by holding the property for a longer period of time and participating in activities like renting the property. However, if the individuals only intent and purpose is to improve and sell the house, then the individual will have no way of qualifying for the 1031 exchange treatment.
The holding period requirement is most important in helping to show that the property to be relinquished is truly an investment or used for trade or business rather than a property being flipped by a dealer. While 1031 exchanges treatment is determined on a case by case basis; generally, it is believed that a holding period from one to two years is sufficient.
Some tax advisors have concluded that one year is sufficient because holding the investment property for 12 months or over will reflect this fact on two of the investor’s tax returns, and Congress once discussed setting a one-year holding requirement for tax deferral treatment. While Congress did not enact this requirement; many believe it reflects what the law was intended to require.
Additionally, in a Private Letter Ruling 8429039, the IRS stated that holding an investment property for two years would qualify the relinquished property as being held for investment.
These conflicting minimum requirements, while not definitive, can be helpful in determining how to show intent of holding the relinquished property as an investment property. Here, the individual should look to how he or she used the property since purchasing and lean towards holding the property for a longer period, if the individual does not believe he or she can prove the investment intent in the event of an audit by the IRS.
Timing and Qualified Intermediary
Once an individual is ready to sell his or her property, the individual will need to be prepared to select a replacement property in a timely manner. Section 1031 requires that the individual identify the replacement property within 45 days of the transfer of the relinquished property. Section 1031 allows for an individual to select three potential replacement properties during the 45-day window and then select and close on the replacement property within 180 days of the date of relinquishing the initial property.
While selling the relinquished property and purchasing the replacement property, the IRS does not allow for the seller or his agents to touch the money in these transactions. Due to this rule, people engaged in a 1031 exchange often hire a qualified intermediary. A qualified intermediary cannot have been an agent of the seller within a two-year period ending on the date of the transfer of the relinquished property and is usually either an attorney or CPA. Here, the qualified intermediary will manage an account where the funds from the relinquished property will be deposited and held by the qualified intermediary until he or she uses the funds to purchase the replacement property on behalf of the individual.
The 1031 exchange process may seem over formalized in some areas making it difficult to complete your transaction, but you must comply with these formalities to benefit from this tax deferral. The rules above show the basics, but many people find complications in areas such as structuring LLCs when working with business partners, achieving investment status with vacation homes, or avoiding classification as a dealer rather than investor.
Compliance is key when engaging in a 1031 exchange, so it’s important to consult someone that can advise you on how your particular situation affects how you move forward with your 1031 exchange. In addition to complying with 1031 exchange rules, it’s also incredibly important to avoid neglecting your other business needs and how these needs may be met in different or atypical ways when involving 1031 tax deferrals.
George Fowler is a business and real estate attorney. Contact him today to learn more – email@example.com.