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1031 Tax Free Exchange A 1031 exchange rolls the gain from your Old investment property over to your New investment property. It’s called a “1031” exchange because 1031 is the IRS Code Section that governs this rollover. The fact that it is an IRS Code Section means that it is law and if you follow the rules the IRS has to allow your exchange. There are six basic rules that you have to follow. These rules must be followed exactly. Failure to follow one small rule can result in your exchange being disallowed if you get audited. RULE 1 - It must be an investment property A 1031 exchange is available only for property held for investment (or used in a trade or business). It does not apply to your primary home. You must own your old property for at least 1 year and a day (“quick fix & flips” are not allowed). A popular question is, “do vacation homes qualify?” The answer is YES. In a 1981 private ruling a tax-payer wrote in and asked if they could do an exchange on a vacation home that they bought primarily for personal enjoyment, but also partially as an investment. They wanted to buy a larger vacation home that they would also hold primarily for personal enjoyment but also partially as an investment. The IRS ruled that they could do an exchange from one to the other provided they could prove their investment intent. How do you prove investment intent? In 2004 a U.S. Tax Court case involving a vacation home in Truckee, CA, dealt with the issue of investment intent. This vacation home near Lake Tahoe had had very little rental in the two years that were subject to the court case. Essentially all of the usage had been personal use of the property by the owners and family members. The IRS ruled that the property was investment property based entirely on the testimony of the taxpayer’s wife that one of the reasons they purchased the property was their expectation that it would appreciate in value. The best way to prove your vacation home was purchased as an investment property is to send your attorney and CPA a letter that says you intend to own the property as an investment with the expectation of appreciation. This is best to do when you purchase the property, but if you already own a vacation home and haven’t done this, consider doing it as soon as possible. RULE 2 – 45-Day Identification Period From the day you close on the sale of your Old Property you have exactly 45 days to make a list of properties you might want to buy. Keep this list to three properties or less. Be sure to list each property by its exact address and give the list to your qualified intermediary (a person we’ll discuss in Rule #4). RULE 3 – 108-Day Reinvestment Period From the day you close on your Old Property, you have exactly 180 days in which to buy your replacement property and whatever you buy has to be on the 45-day list. This means you can buy one or all three of the properties on your list. And like the 45-day requirement, these are calendar days, and there are no extensions. RULE 4 – Qualified Intermediary Requirement You cannot touch the money in between the sale of your Old Property and the purchase of your New Property. By law the money has to be held by an independent third party call a qualified intermediary. Intermediaries have two primary roles: They prepare the exchange documents that are required by section 1031, and they hold the money during the exchange. Be sure to use a reputable intermediary. Here are a couple of reputable intermediaries……. LandAmerica 1031 Exchange Services (800) 879-1031 Jersey Realty Exchange Corporation (609) 391-1031 Any questions you have can be answered by either of these companies. RULE 5 – Title Requirements How you held title to the Old Property is how you have to take title to your New Property. This means you have to stay within the same tax return – the same tax ID number or Social Security number. There are several exceptions to this rule dealing with what the IRS calls “disregarded entities” which are things like revocable living trusts and single member limited liability companies. Contact your intermediary to better explain this to you. RULE 6 – Title Requirements In order to pay no tax, you must do two things: First you must buy equal or up. The second is you have to reinvest all of the cash from the sale of the Old Property into the New Property. Any cash you do not reinvest is taxable. If you sell your Old Property for $500,000 and purchase your New Property for $490,000 you will pay taxes on $10,000. So, what happens to the gain that gets rolled over? Most people want to hear that is disappears, but it doesn't. Your roll over gains are aggregated until you finally sell your last property and don't do a 1031 exchange. There are creative legal ways to avoid paying the roll over gains. Talk to your legal advisor for more information on transferring property to your heirs tax-free. In closing, it is always recommended that you contact your tax and legal advisors to be sure you qualify for a 1031 exchange. - Written by Dennis Allen |