1031 exchange rule gets a heavy change vide the recently passed law-The Tax Cuts & Jobs Act. So, one of the major provision of law that was used by a taxpayer to save on capital gains tax requires fresh look and understanding. Fact is that heavy lobbying by various NGOs for preventing any change to section 1031 has given fruit as most of the benefits as far as real estate is concerned remained intact. But for the benefit of wholesome understanding of 1031 exchange rule in the context of newly passed Tax Cuts and Jobs Act, let answer basic FAQS on this rule
What is a 1031 exchange?
How does 1031 exchange work ? The section 1031 like-kind exchange rule provides that the gain or loss should not be recognized to the extent that property held for productive use in the taxpayer’s trade or business, or held for investment purposes, if such property is exchanged for property of a like-kind that also is held for productive use in a trade or business or for investment.
A 1031 exchange means that if you exchange your property with a like-kind property, any gain on the value difference will not be charged to tax under capital gains. In other words, IRC 1031 allows an investor to “defer” paying capital gains taxes on transfer or sale of an investment property in consideration of a “like-kind property”.
What can be like-kind property?
Like-kind property can be any property held for productive use in a trade or business or for investment. Any type of investment property can be exchanged for another type of investment property. For example,
- a single-family residence can be exchanged for a duplex,
- raw land for a shopping centre, or
- an office for apartments.
Any combination will work. The exchanger has the flexibility to change investment strategies to fulfil their needs.
What are types of 1031 Exchanges?
- Simultaneous Exchange- which basically means you relinquish and close on a replacement property in the same day. Rarely happens nowadays for a variety of reasons.
- Delayed Exchange-Under this type of exchange, a person gets 180 days after the sale or transfer of his property to identify replacement property.
- Reverse 1031 Exchange- you buy first and you pay later. A bit difficult proposition for many because banks may not lend you money as you don’t have the title of the property yet.
- Construction/Improvement Exchange- when There you sell a property and realize that the one they want to buy costs less than the one I relinquished and you need to pay tax on the differential. So, you can opt for this type of exchange that allows you to use the remaining funds to build or improve the property you want to buy.
How much capital gains exchange?
If you want to apply like-kind exchange rule, it must be seen that the net market value and equity of the property purchased must be greater than or at least equal to the property sold. Otherwise, you will have to pay “boot tax” i.e tax on the difference in the value of your property and the property received in exchange. You can test this 1031 Exchange Calculator
What has changed in 1031 Exchange Rule?
As per the Tax Cust & Jobs Act, starting Jan 1, 2018, following changes have come into play
- You can not opt for 1031 exchange on personal property assets. What are those personal properties that are now out of 1031 exchange? The Bill excludes trucks, heavy equipment, autos, farm machinery, artwork, collectables and intangibles like fast-food restaurant franchise licenses).
- If properties are held primarily for sale, such properties will not get benefit of 1031 exchange rule
- If you held virtual currencies, you can not invoke like-kind exchange rule because word property in section 1031 is replaced with “real property”
What type of property clearly out of like-kind-exchange rule?
Section 1031 is not applicable to all kinds of property or all kinds of exchange. Here are certain rules in this regard:
- You cannot trade partnership shares, notes, stocks, bonds, certificates of trust or other such items.
- A 1031 exchange is allowed only for Investment or business property an, not for personal property. In other words, you can’t swap one primary residence for another or an investment property for a personal residence
- Property in a foreign country as the original and replacement property must be within the U.S. to qualify under section 1031.
- Property that is a “stock in trade.” cannot be exchanged. So if you are a dealer in real estate or you are buying and selling at a frequency that IRS regard those transactions as business and properties as stock-in-trade dealers, then also you may not claim 1031 same kind exchange benefit.
Houses built by a developer and offered for sale are stock in trade. If an investor buys “fixer-uppers” and sells them as soon as they are improved, the properties may be considered as stock in trade and cannot be exchanged.