USING A 1031 EXCHANGE TO BUY A VACATION RENTAL PROPERTY
NOTE: an IRS 1031 Exchange is a complex transaction that may require a local, experienced, and competent attorney and accountant! This article is meant to provide a basic overview of a 1031 exchange and to illustrate a way to sell one property, defer any “gains taxes,” and use 100% of the sale proceeds to purchase another property – perhaps a vacation rental property!
I keep hearing about a 1031 Exchange. What is it? Can I use it to reduce my capital gains taxes on the sale of a property?
Internal Revenue Code §1031 represents the ability to defer federal capital gains and recaptured depreciation taxes when selling real or personal property held for investment, in the production of income, in a business and replacing with real or personal property held for investment, or in the production of income or in a business.
By deferring the tax, the Exchangor/Owner is able to use it as additional capital towards the purchase of more real or personal property. Rather than paying the tax which is then deferred until the sale of the replacement property, the gain or the dollars it represents can be used to purchase a greater value of property, thus maximizing the marginal use of each taxable dollar.
Short Term Capital Gains VS Long Term Capital Gains
Reporting on real estate selling transactions
When you make a profit on the sale of an asset you’ve held for one year or less, that’s defined as a short term gain. A long term capital gain is the same, except the asset being sold was held for 366 days or more before the sale closed. Why is this important? Simple – the capital gains tax on a short term gain is HIGHER than that on a long term gain. MOST real estate transactions are held for 1 year or more before sale – for obvious reasons!
I know that capital gains taxes are paid on the sale of gains on regular investments, but what about when I sell a piece of real property, like my home, unimproved property, or commercial building, etc.?
Let’s take the sale of your primary residence out of the equation – there are special rules and exemptions on any gains from that sale. Investment/business property ownership has its perks. Done right, you can get a recurring revenue stream. Hopefully your mortgage and other fixed expenses are covered and you can see a profit each month, not to mention a possible windfall when you decide to sell!
But that income-generating machine can cost you if and when you sell. After all, the IRS is going to want a cut of it in the form of capital gains taxes. Capital gains taxes come whenever you sell an asset for a profit. For 2015 and 2016, the capital gains tax rate is 15% for people who fall into the 25%, 33% and 35% income tax brackets. People in the 39.6% tax bracket pay 20%. That could be a significant hit depending on your profit. If you are getting $100,000 on the sale, you’ll owe $15,000 in taxes. While we can’t avoid taxes, there are ways to reduce the burden when selling an investment/business property.
What does this mean for me?
Here’s an example:
You purchased a rental property for $50,000 with a $25,000 loan, and after 10 years you sold that same property for $150,000. The structure at time of purchase was valued at $25,000 and was depreciated each year totaling $9,091. Selling expenses include realtor sales commission, title insurance, and other associated closing expenses of $13,500. The total capital gain from that sale is $95,591.
If a 1031 exchange is initiated, the total tax deferred is $15,248 (recaptured depreciation of $2,273 + Federal capital gain $12,975). Rather than exiting the closing with after-tax equity of $96,252, initiate a 1031 exchange, reinvesting $150,000 or more in the replacement property and allowing the $15,248 to continue to work in your interest. Effectively, the 1031 is an interest free loan of $15,248 allowing a cash infusion to fund new opportunities.
1031 Exchanges | Q & A
Can I offset taxable gains with losses?
An effective way of reducing your tax exposure when selling a rental property is to pair the gain from the sale with a loss in another area of your investments. Called tax loss harvesting, many people employ this strategy at the end of the year to reduce the amount they owe from stock gains, but it can also be used for investment/business real estate property. That’s because the IRSlets you pair gains with losses to lower the amount you owe. If you made $50,000 off the sale of a rental apartment but took a hit in the stock market and lost $75,000, you can offset $50,000 and effectively make the profit from the sale of the rental property a wash.
Can the gains from the sale of an investment property be converted into a primary residence?
Yes. An investment/business property can be converted into a primary residence as long as the Exchangor/Owner did not have a concrete intent to convert at the time of purchase. If the property is converted soon after the purchase, the IRS will most likely want to talk with you. If you have an undefined intent to build a home or the possibility of conversion exists but no definite plans have been established or architectural drawings have been created, then this intent should not prevent the conversion.
What are the tax consequences when the primary residence represents replacement property in a 1031 exchange?
Now that the property is held as a primary residence, it is subject to §121 and is eligible for the $250,000 (if filing single) or $500,000 (if filing jointly) gain exclusion. The property must be held for a 5 year period beginning when the property was initially purchased as a replacement property. The §121 exclusion does not apply to the years the property was held as a rental property or not as the Exchangor's principal residence, otherwise known as "non-qualified use."
Given 2 years held as an investment property, converted to a primary residence in year 3 and later sold at the end of the 5th year, the property is sold for a realized gain of $300,000. Two fifths of the gain is non-qualified representing $120,000 for the 2 years held as an investment property. Three fifths or 3 years is eligible for the gain exclusion or $180,000. There are multiple variables to consider when determining the tax consequences.
Do I need to reinvest only the net equity?
If the objective is to defer the entire Federal capital gain and recaptured depreciation, then both the debt retired at the closing and the net equity otherwise known as exchange proceeds must be reinvested. The first dollar received at closing is taxable.
What about the earnest money deposit or funds used to improve the property? Can I take that out without having to pay federal capital gains tax?
The IRS views this as taxable. Funds once in an exchange and removed will be taxed twice. You can receive the cash at closing, but it will be taxed.
Can I do a partial exchange?
Yes. Talk with your accountant to determine whether it is in your interest. There is a point once you get close to removing 50% of the total value (net equity plus debt retired) that it does not make sense to initiate an exchange.
Can the replacement property be purchased from a family member?
Yes, if the family member is also exchanging into another property. If the family member is cashing out, the answer is no.
Can the relinquished (old) property be sold to a family member?
Yes, but the family member cannot sell the property for 2 years; otherwise their transaction will trigger the tax you have deferred. The IRS is looking for what is called related party transactions on Form 8824 used to file the 1031 exchange with your yearly Form 1040.
What is a related party?
The term "related party" is any person bearing a relationship to the Exchangor described in Section 267(b) or 707(b)(1) including:
- Family members (siblings, spouse, ancestors, and lineal descendants);
- Individual and corporation, when more than 50% in value of the stock is owned directly or indirectly by or for such individual;
- Two corporations part of the same control group;
- A grantor and fiduciary of the same trust;
- A fiduciary and a beneficiary of the same trust;
- A fiduciary of a trust and the fiduciary or beneficiary of another trust where the same person is the grantor of both trusts;
- A fiduciary of a trust and a corporation more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for the grantor of the trust;
- A person and a Section 501 organization, if the organization is controlled by that person or that person's family;
- A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of capital interest or profits interest in the partnership.
- An S corporation and another S corporation or a C corporation if the same persons own more than 50% of the value of the outstanding stock of each corporation;
- A partnership and a person owning, directly or indirectly, more than 50% of the capital interest, or profits interest, in such partnership;
- Two partnerships in which the same person owns, directly or indirectly, more than 50% capital interests or profits interests; and
- An estate executor and the beneficiaries of the estate.
Does the relinquished property need to be held for a certain amount of time?
The general answer is no; however, a 1 year hold time is suggested. The shorter the hold time, the more supportive the facts need to be. Exchanges are composed of intent and facts. Hold time is one fact of many that support the intent to defer the taxes in a 1031 exchange.
If the relinquished property is a vacation home, Revenue Procedure 2008-16 applies effective for exchanges after March 10, 2008. The investment property must be held for 24 months prior to the sale and in each of the two 12-month periods: (1) the Exchangor rents the relinquished property to another person or persons at fair market rental for 14 days or more; and (2) the Exchangor's personal use must not exceed the greater of 14 days or 10% of the number of rentals days for that period. The replacement property of a dwelling unit must adhere to a 24-month hold and usage requirements.
Can I exchange personal property for real property?
No. Real property can be exchanged for any real property; land for rental or storage units for parking garage. Personal property must be exchanged for the same class or kind of personal property.
Can foreign property be exchanged for US property?
No, US property must be exchanged for US property while foreign property must be exchanged for any foreign property.
Can a self-directed IRA purchase property I own or from a family member?
The general answer is no. You cannot purchase from yourself or ascending or descending family members. The IRS is gray on whether you can purchase from your brother or sister.
I am a developer of residential homes and commercial properties. Can I use the 1031 exchange?
Yes, if those properties you wish to exchange are held separately from the properties you hold as inventory. Hold the properties either under a different company or at least have the properties accounted for differently as on a separate balance sheet. Inventory is not eligible for 1031 consideration.
Why should I consider a 1031 exchange when selling an investment property?
The tax deferral that can represent upwards of 40% of the sale given a federal capital gains rate of 15% allows you to purchase more property, translating into greater appreciation and ultimately greater profits. In addition, there are a number of other reasons unrelated to the Federal or State tax deferral including:
- The taxpayer is moving to another location, city, or state and wants to be close to the property.
- The old property is located in an area that is no longer appreciating as fast as another locale.
- Greater cash flow can be generated by a rental property versus land.
- The old property has been or is close to being fully depreciated; exchange to benefit from greater depreciation.
- The Exchangor wants to exchange several smaller investment properties into one or consolidate.
- The Exchangor wants to diversify from one property into many smaller properties.
Is a 1031 exchange really tax free?
Yes AND no. If you die with the property and it is gifted to your heirs, your beneficiaries receive the property at the stepped up basis - not at the price you paid for it. Otherwise, a 1031 exchange defers the tax liability indefinitely until the replacement property is sold. There is no limit to the number of 1031 exchanges you can initiate.
What is recaptured depreciation?
The IRS generates revenue or collects income taxes on the gain of an asset when sold. The gain is determined in three easy steps:
- Determine the adjusted basis. Adjusted basis is the original purchase price plus improvements less the total depreciation taken each year on Schedule E of the taxpayer's federal 1040 income tax return.
- The sales price less the adjusted basis less the selling expenses of sales commissions and closing costs equals the realized capital gain.
- Subtract the depreciation from the realized gain and multiply by 25%. The remaining amount is then multiplied by 15% given the property was held for at least one year and a day and the taxpayer's bracket is 25% or greater. If the hold time is less than one year, add the gain to taxpayer's income to determine the income bracket tax rate. This result is known as the recognized gain representing the amount of tax due. This is also the amount of tax dollars deferrable in a 1031 exchange.
Given the depreciation allows the taxpayer to annually deduct a portion of the asset's basis reducing the taxpayer's income tax due, the IRS charges back or recaptures 25% of what was depreciated. With bonus depreciation of 50% and more, the recapture depreciation can be a large amount.
Will YOU benefit from using an IRS 1031 Exchange in your purchase of vacation rental property? Maybe! You may be able to use this financial planning concept to get out from under a property AND use more of the sales proceeds to purchase a better and more profitable property. It could be a WIN - WIN!
Thank you again for your interest in Cabins for YOU. We hope this article helps answer your questions. If not, we’d like to invite you to call us so we can speak personally on your individual situation. To learn more about Cabins for YOU and our property management platform, please give us a call or send an email to:
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