One of the advantages of investing in real estate is provided under the Internal Revenue Service, Code 1031. The tax on the profit from a real estate sale can be delayed until a later date when you enter into a qualified exchange or purchase. Because of the tax code number that allows these transactions, you may hear people simply refer to these exchanges as “1031s”. The 1031 exchange allows for the sale and purchase (exchange) of “like-kind” real estate while avoiding immediate tax consequences. The tax deferral impact created by using a 1031 exchange helps you grow your real estate investment portfolio faster. It’s similar to the way a 401k or an IRA allows for tax deferred compounding of stock investments. You invest with pretax dollars rather than after tax dollars.
The 1031 tax deferred transaction has specific requirements and timelines that must be met in order for the deal to qualify. One of the most important things to know is that you need to have a 1031 strategy in place before selling your property. You need to employ a qualified intermediary to handle the transaction. The property owner can not receive the funds from a sale directly but rather the proceeds are held by the intermediary. You will not be able to defer a gain on any monies received into your possession no matter how short the period. Expect to pay a small fee for the service of the administrator.
What are “like-kind” exchanges? In the simplest example, consider selling a vacant commercial lot and then purchasing a more expensive/larger vacant commercial lot. Selling a warehouse that housed an HVAC business and exchanging into a vacation home would likely not qualify as the purpose of the two properties is different. The idea is that you are selling one thing and replacing it with another that is similar in nature and purpose. Not all real estate transactions qualify. Vacation property and second homes can qualify but must meet specific criteria.
Regarding vacation property and second homes the IRS has offered conflicting opinions over the years. Most recently the Treasury has clarified their opinion to state that the investor’s primary intent is the critical factor in determining whether a property was held for personal use and enjoyment, or whether it was held for investment purposes.
Revenue Procedure 2008-16, which was effective beginning March 10, 2008, provides a number of safe harbor guidelines
The sale of a vacation property or a second home will qualify for tax-deferred exchange treatment if the following safe harbor requirements have been met:
- The subject property has been owned and held by the investor for at least 24 months immediately preceding the 1031 Exchange (“qualifying use period”); and
- The subject property was rented at fair market rental rates to other people for at least 14 days (or more) during each of the preceding two (2) years; and
- The investor limited his or her personal use and enjoyment of the property to not more than 14 days during each of the preceding two (2) years, or ten percent (10%) of the number of days that the subject property was actually rented out to other people during each of the preceding two (2) years.
The purchase of a vacation property or a second home will qualify as replacement property in a tax-deferred exchange transaction if the following safe harbor requirements are met:
- The subject property is owned and held by the investor for at least 24 months immediately following the 1031 Exchange (“qualifying use period”); and
- The subject property was rented at fair market rental rates to other people for at least 14 days (or more) during each of the following two (2) years; and
- The investor limits his or her personal use and enjoyment of the property to not more than 14 days during each of the following two (2) years, or ten percent (10%) of the number of days that the subject property was actually rented out to other people during each of the following two (2) years.
Always consult with your CPA, an attorney, and an exchange specialist for their professional advice and the latest regulations on these exchanges. Exchanges are highly effective in helping you to grow your real estate investment portfolio but must be used in accordance with current tax law. These professionals will help you structure complex transactions within safe harbor guidelines. Give me a call to discuss your possible need for a tax deferred exchange and assistance is locating a qualified intermediary.
Tad Hunter is a licensed real estate agent with LAH Real Estate and a partner in the RealJoy Vacations company. He and his wife and children are residents of Sandestin. Tad enjoys the Grateful Dead, Steve Martin jokes and prefers puppies over kittens.
Personal disclaimer– do not use this article for tax advice as it is intended to be informational only and I do not offer tax or financial advice that can only be provided by licensed professionals.