By Marianna Perez
Luxury Sales Associate
Marianna E. Perez is a Real Estate professional with over 20 years of experience. Prior to entering real estate, Marianna was Senior Vice President of Commercial Real Estate Banking at City National Bank of Florida. She provided strategic leadership facilitating profitable and efficient origination of real estate loans. Marianna was a trusted advisor to clients and to the bank growing a real estate portfolio to over $300 million.
Did you know that…
Often investors do not realize taxation on a personal residence is far different than taxation on income or investment property. The Taxpayer Relief Act of 1997 changed the IRS code for the sale of personal residences to allow single taxpayers a $250,000 exclusion and a $500,000 exclusion for married couples from capital gain tax. In order to qualify, the taxpayer must have resided in the property for two of the last five years. This exemption may be used once every two years.
If an investor sells appreciated property, they pay tax. However, property that qualifies for preferential tax treatment under IRS Code Section 1031 (IRC § 1031) is treated quite differently. Under Section 1031 a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property; a process known as a 1031 exchange.
To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business, or for investment. The properties exchanged must be of “like kind”, (i.e.) of the same nature or character, even if they differ in grade or quality.
To elect the 1031 recognition, a taxpayer must identify a replacement property/properties within 45 days of closing and acquire the replacement property within 180 days of closing. A Qualified Intermediary must also be used to facilitate the transaction. The intermediary holds the proceeds of the sale and then disburses those monies upon closing on the replacement properties.
Time Limits for a 1031 Exchange
The §1031 exchange begins on the earliest of the following:
- the date the deed records, or
- the date possession is transferred to the buyer,
and ends on the earlier of the following:
- 180 days after it begins, or
- the date the Exchanger’s tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.
In order to qualify for an exchange, certain rules must be followed:
- Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
- The asset must be of like-kind. Real property must be exchanged for real property, although a broad definition of real estate applies and includes land, commercial property and residential property. Like-kind does not refer to the type of property. Instead it addresses the intended use of the property. For example:
- A duplex for a fourplex.
- Bare land for improved property.
- A rental house for a retail center.
- An apartment building for an office building.
- Investors do not have to exchange for the same type of property as relinquished.
- The Tax Code lists items that are not considered “like-kind”. These include:
- Stock in trade or other property held primarily for sale.
- Stocks, bonds or notes.
- Other securities or evidence of indebtness or beneficial interest.
- Interest in partnership.
- Property outside of the US is not “like-kind”.
- The proceeds of the sale must be re-invested in a like-kind asset within 180 days of the sale. More than one potential replacement property can be identified during the 45-day required identification as long as you satisfy one of these rules:
- The Three-Property Rule – Up to three properties regardless of their market values. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
- The 200% Rule – Any number of properties as long as the aggregate fair market value of all replacement properties does not exceed 200% of the aggregate Fair Market Value (FMV) of all of the relinquished properties as of the initial transfer date. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
- The 95% Rule – Any number of replacement properties if the fair market value of the properties received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified. In other words, 95% (or all) of the properties identified must be purchased or the entire exchange is invalid. An exception to the 95% rule is that if you close on a property within the 45-day period it still qualifies for the exchange.
Section 1031 & Second Homes
There is and has been much confusion surrounding the use of Section 1031 and second homes. Although most taxpayers purchase second homes with the expectation of appreciation, the IRS has ruled that properties that are purchased for personal use are NOT investment properties, and therefore do not qualify for Section 1031 treatment.
IRS Revenue Procedure 2008-16 defines what is acceptable. This revenue procedure creates a safe harbor for taxpayers wishing to use Section 1031 with properties that follow a simple set of rules as follows:
For a minimum of two years prior to, and after the exchange:
- The property must be rented for a minimum of 2 weeks to a non-relative.
- You can rent to a relative if it is their primary residence at fair market value rent.
- The property must only be used personally for 2 weeks or 10% of the time rented.
- You can maintain the property for an unlimited amount of time, but documentation must be kept for these activities.
- The property should be placed on Schedule E of your tax return and reported as income property.
Calculation for a 1031 Exchange
- Subtract the adjusted basis from the sales price (Adj. basis is determined by the original purchase price plus capital improvements, minus depreciation taken over the period of ownership).
- Next, from your current sales price subtract the transaction costs (commissions, fees, etc.) This is the capital gain and the amount of gain deferred if you exchange.
- Finally, multiply the capital gain by your combined tax rate (Federal and State if applicable) to determine your estimated tax. This is the amount you will save if you exchange.
The true power of exchanging is the ability to meet investment objectives without losing equity to taxation.
The 1031 exchange process is a complicated matter and a qualified CPA and Real Estate Attorney should always be consulted.