In a hot real estate market, valuable commercial property can present a bit of a problem. Maybe you want to sell your property, but you can’t afford the massive tax bill associated with the realized capital gains. What are you to do? The answer is simple. Use a 1031 exchange when selling real estate for a profit.
What Is a 1031 Exchange?
So, what exactly is a 1031 exchange? A 1031 exchange refers to section 1031 of the Internal Revenue Code. It allows you to defer the payment of capital gains taxes if you sell an investment property and use the profit to purchase another “like kind” property. This tax burden reduction strategy is often used by real estate investors. However, it can also be used by business owners or homeowners.
Unfortunately, not just any homeowner can take advantage of this tax law when selling real estate. For example, most homeowners purchase second homes expecting the value to appreciate. However, if these properties are used as a personal temporary residence, like a summer home, they can’t be counted as investment properties. Here are the requirements for using a 1031 for the sale of a second home:
- Rented for at least two weeks to a non-relative
- Rented to a relative as a primary residence at FMV rent
- Used personally for no more than 10% of the time rented or two weeks
- Found on Schedule E of your tax return as income property
- Documentation maintained for maintaining the property
You must follow the above guidelines for two years before and after the sale of the secondary home. In other words, you can’t purchase a like-kind second home with the profit from selling the first home and sell the new property a year later.
Recent Developments in Tax Law
Prior to 2018, capital gains taxes could reduce the resulting tax burden of selling several types of property for profit. However, the TCJA, or Tax Cuts and Jobs Act, repealed that. Now, Section 1031 applies only to real property.
How to Calculate Adjusted Basis
The hardest part of filling out Form 8824 is calculating your adjusted basis. If you’re new to selling real estate, you may not even know where to begin. Start with the original purchase price of the property. This includes the price of the home, any real estate taxes you paid on behalf of the seller, and any legal fees you paid to get the property.
Then, add any improvements you made to the property less depreciation. Subtract any casualty losses suffered that were not repaired.
Using a 1031 Exchange When Selling Real Estate
What steps are involved in using a 1031 exchange when selling real estate? There are seven basic steps. It starts with selling your investment property. Second, you must give your capital gains to a qualified intermediary to hold. Third, you must find a like-kind property within 45 days. Fourth, negotiate with the seller of the like-kind property you want to buy. Sixth, come to an agreement on the sales prices. Finally, fill out the IRS form.
Who Is a Qualified Intermediary?
You can’t just give your profits to a friend or relative to hold on to. In most cases, the IRS excludes relatives or anyone with a financial relationship to you within the past two years before you closed on your escrow. This includes employees and currently attorneys, accountants, real estate agents, brokers or investment bankers.
Your qualified intermediary, also known as an accommodator, must be bonded and insured against errors and omissions. Ideally, you should use someone with an educational or professional background in tax, law, or finance. It’s also important to remember that even though accommodators in Nevada are required by law to be licensed, there is very little regulation governing these professionals.
Important Things to Remember
The first thing you need to remember about using a 1031 exchange when selling real estate is it’s not for personal use. It only applies to investment property or business property. The TCJA limited the use of a 1031 exchange to real estate.
The definition of like-kind is extremely vague. For example, you could sell an apartment complex and purchase raw land or an outlet mall. A qualified intermediary is used to hold on to the gains until a like-kind property is purchased because it’s unlikely that you’ll have one lined up immediately following the sale of your property.
There are only two non-negotiable deadlines when it comes to getting tax deferment through a 1031 exchange. First, you must identify a like-kind property within 45 days of selling your initial property. Second, you must close on this property within 180 days of selling your first property.
Any cash left over after purchasing your new investment property is considered “boot” and will be taxed at the capital gains rate. Let’s say that after your adjusted basis, you see gains of $250,000. You give that money to a qualified intermediary, and he uses it to purchase two properties for a total of $190,000. You must pay capital gains tax on the $60,000 that wasn’t used to purchase a like-kind property.
Moreover, the IRS sees a reduction in mortgage as a boot. For example, you have a $2.6 million mortgage on a property. You sell it and purchase a like-kind property with a $2.2 million mortgage. That $400,000 reduction in mortgage is considered boot and will be taxed at the capital gains rate.
The Bottom Line
Many people feel they can’t afford to sell their commercial or secondary residential property when the real estate market is hot. When selling real estate for a significant profit, savvy taxpayers file Form 8824 to defer the capital gains taxes incurred during the sale. The most important thing to remember when considering a like-kind exchange to save you money on your tax bill is that your qualified intermediary cannot have a relationship to you except in extreme circumstances. Finally, the like-kind property must be purchased within 180 days of the sale of your property.