Real estate is a popular investment vehicle and there are some useful tax breaks that investors should be aware of. One of those which has been becoming more popular over the past 10-15 years is known as a 1031 exchange, named after section 1031 of the tax code.
Here is the background: In March 2002 the IRS issued new guidelines called Rev. Proc. 2002-22. These guidelines were created to help buyers and sellers of real estate who were conducting 1031 exchanges. These special property sales were based on the exchange of the property for a “like-kind” property. This exchange allows the sellers to defer paying capital-gains taxes on the sale. In the broadest of terms, the investor is swapping (exchanging) one business or investment asset for another. Even though most swaps are taxable as sales, if you come within the parameters of section 1031, there will be either no tax or limited tax due at the time the exchange takes place.
Back in 2002 IRS ruling addressed itself to something called a Tenant in Common, or a TIC. A TIC allows investors to own just a partial interest in a 1031 property, which can be entities such as shopping malls office buildings, and other commercial properties. The ruling established the fact the TIC properties indeed qualify as a realistic option for 1031 exchanges.
Most sponsors, or firms which create TIC deals, demand relatively high minimums, usually around $250,000. In the past there have been some firms with considerably lower minimums, however. Some niche firms set the limit as low as $50,000, such as Rob Hannah’s Strategies Group LLC, a company that specialized in structuring and then selling shares in TICs.
There are a few caveats when considering the use of a 1031 exchange to defer taxes.
- A 1031 exchange is not allowed for personal use, only for investment and business property.
- A 1031 exchange does not always have to be real estate, although it usually is. It is even possible that the sale of a work of art can be considered qualified for a 1031 exchange.
- The definition of “like-kind” is wide. The terminology here can be misleading so check before you make any deals.
- You are allowed to do what is known as a “delayed exchange.” Because the chances of immediately finding someone with the exact property you want who also wants the exact property you have means that most exchanges are delayed via three party (Starker) exchanges. This type of exchange requires a middleman who holds your cash after you sell your property. He then uses that cash to buy your replacement property on your behalf. This three party trade is considered a swap.
- There are two important timing rules to keep in mind when conducting a delayed exchange. Once you sell off your property the third party intermediary gets the cash, and within 45 days of the sale of your property you have to designate the replacement property in writing to that same third party intermediary. The second restriction is that you must close on the new property you are purchasing with 180 days of the sale of the old property.
- As soon as you receive the cash for your property, it is taxed.
There are a few other rules to be aware of. As you can see, 1031 exchanges are not simple things, and we recommend getting advice from a professional before jumping in to this potentially lucrative tax benefit for investors.