There are a many types of exchanges, but 2 primary 1031 real estate exchanges: the straight exchange and the reverse exchange. You'll need to be up to date on IRS safe harbor guidelines for vacation home exchanges.
If you currently own rental property and you find your dream home in Key West FL while you are on vacation and decide that you want to retire in Key West some advance planning may save you a bundle in taxes.
Imagine that you purchased a rental property 30 years ago for $100,000. The property could now be worth $900,000. If you sold it you would owe $120,000 in taxes. If you did a 1031 exchange you would defer taxes and save $120,000 now that you could put toward the purchase of a new rental property for $1 million.
Later you might convert the investment property to a primary residence or exchange the property for estate planning purposes to make sure each of your children has an equal investment property that they inherit.
You could do a 1031 exchange of an investment property that you currently own. Exchange the current investment property for a new property where you want to live after retirement. Rent out the property until you retire. After retirement, establish the new property as your primary residence and live in the property for 2 years. If it has been at least 2 years since you sold your primary residence you can again exclude $250,000 (single person) or $500,000 (if married filing jointly) of the gain that you have made on your converted property.
Here are a few more talking points to discuss with your CPA and tax attorney!
If you rent your home for less than 14 days per year you don't report or pay tax on income. There is no tax deduction.
If you rent the home for more than 14 days per year or 10% of the time you must report all income. All income is taxed. Your deductions for rent related portion of expenses can offset income.
You can deduct interest on the mortgage debt, points, fees, real estate taxes and casualty and theft losses, depreciation, advertising, cleaning, repairs and maintenance, insurance, commissions, tax preparation fees, travel and local transportation expenses.
Rental use is defined as an available rental period that the property is not rented at a fair rental price, but is used for personal purposes.
Days when the property is not available for rent and vacant are not included in the calculation.
Expenses are prorated using a ratio of rental use to total days of use. For example, if you own a home in a ski area and the rental period is 160 days and you used the property for 60 days the total days used would be 220 days. I say ski area because we can all agree that there are certain months that qualify as ski season. In Key West it's a little different. We get vacation guests all throughout the year even though our high season is December 15 through May 15th.
Ex: 160 divided by 220 = .727 or .73 or 73% of expenses are deductible.
All real estate rental activity. Deductions cannot exceed income or offset other income. You cannot carry over excess losses.
Losses are limited by income generated by the activity. You cannot use passive income to offset regular income. High income earners cannot use excess losses in passive activities to offset high income. You can carry a loss forward to the next year. You can only deduct a passive loss from passive income.
10% ownership and management level decisions. You must be actively involved in tasks such as choosing tenants, deciding rental terms, approving expenditures and approving expenses. Your management agreement with a property manager should not characterize your involvement as 'not active' or 'not material'.
You cannot have active participation in a short term rental. The limit is $25,000 for loss and expenses. The deduction is phased out if the MAGI exceeds $100,000. If income is greater than $100,000 consult a CPA.
You must have regular, continuous and substantial involvement. The determination is made year to year. All losses and expenses can be deducted in the current year to offset other income.
To claim material participation you must meet 1 of the following:
1. Work less than 500 hours in the business
2. Do most of the work
3. Work more than 100 hours, and no one including non-owners or employees, works more hours than you.
4. Work between 100 and 500 hours participating in several passive activities and the total time is less than 500 hours.
5. Materially participate in a personal service activity for any of the 3 prior years.
The IRS views a qualifying real estate professional who owns rental properties as having material participation. To meet the IRS criteria for material participation you must meet BOTH of the following criteria:
1. More than 1/2 of the tax payers personal services are performed in real property businesses.
2. Less than 750 hours are spent in those businesses in which there is material participation. Sales, teaching, leasing and appraising are accepted activities.
Cost Recovery is defined as recovery of cost of the property and improvements over time. An investment property can be depreciated over 27.5 years. Only the structure may be depreciated. The land cannot be depreciated.
Bifurcation is defined as taking all of the component parts that can be depreciated. Be certain that you have the correct schedule of depreciation for all of the items. For example, furniture is depreciated more quickly that real estate. Yard improvements are depreciated on a different schedule.
When you sell an investment property you will recapture all of the depreciation and the depreciation will be taxed at 25%.
1 in 3 investment properties are converted to personal use. You loose the expense deduction when you convert a property to personal use.
2 years of residency reclassfies property as a personal residence. A personal use property is eligible for the $250,000 (single person) or $500,000 (married couple) exclusion on the gain. The deductible portion of the gain is prorated between the personal and rental / investment use.
If you have owned the property for 10 years and moved in 2 years ago it is a taxable event. Be certain that you document the 'repurposing'. An owner can mail a letter to themselves and their accountant stating the intention and desire to switch the use of the property to personal use. A domicile or homestead property is one where you pay taxes, have your drivers license and voters registration.
Effective January 1, 2009 you must pay capital gains tax on the sale of a primary residence (converted home) used as a 2nd home (non qualified use). When you sell your primary home that was once a 2nd home you cannot claim the full $250,000 (single) or $500,000 (married) capital gain exclusion. The taxable portions of a gain are based on the percent of non qualified use.
The gain X (times) the non qualified use / (divided) by the entire time of ownership after January 1, 2009 = the taxable gain on the percentage of use.
Ownership or use prior to January 1, 2009 does not figure in to the calculation.
An exchange does not have to be simultaneous. It's difficult to find 2 identical properties to exchange.
1. Property held for investment of productive use in trade or business.
2. Exchanged for like-kind (investment property = multi unit, land, condo, strip mall, etc.).
3. The replacement property must be identified before the 45th day after the day that the relinquished property was transferred.
4. The replacement property, or properties, must be purchased no later than 180 days after the tax payer transfers the property or the tax due date (April 15), with extensions, in which the transfer took place.
~ Defer, Defer, Die
Recognize when an exchange is possible and advantageous. Work with a team of experts to ensure a smooth transaction.
Always calculate how much capital gains tax you will owe in a straight sale. If a straight sale will not result in a large tax consequence you might choose to skip the 1031 exchange.
1. Based on the property use.
2. Both replacement and relinquished property must meet criteria.
3. Must be a true exchange and not a sale and purchase.
4. No Dealer Property.
Dealer property is defined as property held for resale. Property held for less than 1 year is not eligible for a tax deferred 1031 exchange. Real estate professionals are not automatically dealers when exchanging their own property. Consult a tax professional to assess your complete financial circumstances and receive direction.
If you are working with a seller that is subject to FIRPTA withholding and doing a 1031 tax free exchange the title company will withhold 10% of the purchase price on behalf of the buyer for taxes until the IRS approves the Withholding Certificate. If for some reason the exchange was not approved then the buyer would be responsible for the 10% tax if nothing was withheld in escrow. Even though the 10% tax may not have to be paid in a 1031 exchange the money must be withheld.
The IRS will not challenge a sale if the property:
1. Is owned for 24 months.
2. Is rented more than 14 days per year and the tax payers use does not exceed 14 days or 10% of the days rented.
You must own the replacement property for 24 months after the 1031 tax free exchange.
1. Tax Deferral Defer, defer, die.
2. Diversification An investor may not want all of their eggs in one basket.
3. Financial Strategy An investor may want to exchange a property with no income for a property with income.
4. Lifestyle An investor may relocate and want to continue to earn income in the new location.
5. Free Up a Tax Locked Property An investor may have taken all of the depreciation that is allowed (27.5 years) and by trading properties the investor can begin to depreciate the new property.
6. Estate Planning An investor may own 1 property and have 2 children. The investor may sell the 1 property and purchase 2 identical properties so that both children have their own property that they will inherit.
7. Avoid Cost Recovery Recapture When an investor has fully depreciated a property and sells it the investor must pay taxes on the depreciation. An investor can avoid the the tax on the cost recovery recature with a 1031 tax free exchange.
Does the owner act like an investor? Investment must be the primary objective in a 1031 tax free exchange.
Holding a property in anticipation of value appreciation may not qualify the property as a 1031 exchange if investment is not the primary objective. The owner must act like an investor.
In 2007 a tax court ruling against the Moore family established investor rules. The Moore family had a 2nd home that was a vacation home. The family later bought a 3rd home that was a vacation home in a different location. The Moore family stopped using the 1st vacation home. The 1st vacation home was vacant.
The family did not maintain the 1st vacation home and did not take deductions for upkeep or depreciation on the 1st vacation home. The Moore family claimed an interest deduction on both vacation properties as home mortgage interest rather than an investment interest expense. The family made no effort to rent the vacation home.
An investment home can be used for no more than 14 days per year or no more than 10% of the availble rental period when the property is rented at fair market value during a 12 month period. When claiming a 1031 exchange the primary purpose of the investment property cannot be a vacation home for the owner and the owner's family.
The tax court said that the Moore family actions proved that the 1st vacation home was not an investment property and disallowed the 1030 exchange.
1. Deferral of capital gains tax.
2. Basis step up and capital gain forgiveness for heirs.
3. Free up a tax locked property.
4. Conserve cash for reinvestment ~ taxes on gain are deferred.
example: traditional sale vs 1031 exchange
Traditional Sale 1031 Exchange
Proceeds from sale $250,000 $250,000
Federal capital gains tax $ 22,500 $0
Depreciation recapture $ 5,000 $0
Available for reinvestment $222,500 $250,000
Extra money available for reinvestment in a 1031 tax free exchange: $27,500
1. Strict adherence to time limits. The relinquished property must be identified in 45 days. The reverse exchange must be completed (closed) within 180 days of taking title by the qualified intermediary. There is absolutely no flexibility with the time lines. The dates are mandated by Congress and cannot be extended by even 1 day.
2. Future tax rates could be higher.
3. Basis carry over from relinquished property.
4. Complex transaction with expenses that are not customary in a traditional sale.
5. No recognition of losses.
6. Tax consequence if the net proceeds are not reinvested in real estate.
7. Tax consequence if a property received in an exchange between related parties is disposed of within 2 years of the exchange. The original sale will not qualify for non recognition of the gain.
Boot is defined as cash and unlike property that a seller may keep rather than putting into the next property that is purchased. Boot is taxable. Boot does not defeat an exchange. The tax on boot cannot exceed what the fully taxable transaction would be.
The maximum number of properties that you may identify to purchase is 3 properties at fair market value. The replacement properties must be described in writing by legal description, street address and or the name. If one of the properties is an apartment complex called 'Paradise by the Sea' the name must be in writing.
You may identify any number of proprties to be purchased before the end of the end of the Identification Period, but the aggregate value cannot exceed 200% of the relinquished property. You figure fair market value of the relinquished property on the date that you transfer them.
You may identify any number of properties to purchase as long as the aggregate value of the property acquired during the exchange period is equal to 95% of the full market value of the relinquished properties.
Avoidance is key to a successful exchange. A tax payer must avoid actual receipt and constructive receipt. A tax payer cannot be related to a qualified intermediary or an escrow agent in the transaction. A tax payer cannot use a an attorney that has represented the tax payer in legal matters during the 2 years preceding the sale of the relinquished property. The proceeds of the sale must be placed in escrow with a neutral third party (qualified intermediary).
Actual Receipt is defined as cash or property that are in the tax payer's possession.
Constructive Receipt is defined as cash or property that are available for the tax payer to draw on or control.
There are 4 safe harbors for the tax payer. The tax payer must avoid actual or constructive receipt. The tax payer may use more than 1 safe harbor. The tax payer's use of a safe harbor does not guarantee the successful completion of a tax free exchange.
1. Escrow accounts and trusts.
2. Qualified intermediary.
3. Security or guarantee arrangements.
4. Interest or growth factor on money or property held in exchage.
Qualified Intermediaries are not licensed. There is no requirement for insurance or bonding for a qualified intermediary. Experience counts so be sure to ask around. A qualified intermediary may be certified with an Exchange Specialist Certification. A qualified intermediary should have errors and ommission insurance (E & O insurance). Qualified intermediaries make money from interest on the funds that are held in escrow. A qualified intermediary should not comingle a client's funds. Resignation by a qualified intermediary disqualifies the exchange.
Seller Sam owns an apartment building in New York.
Buyer Bob buys Seller Sam's apartment building for $1 million.
The $1 million cash from Buyer Bob goes to the qualified intermediary.
The $1 million cash goes to Seller Sara to buy a multi unit building in Key West FL for $900,000.
A Starker Exchange allows an owner who sells an investment property that they have been renting to defer the 15% taxes on appreciation and 25% of the recapure of the depreciation deduction that you have taken. A Starker Exchange was made possible by a precident setting law suit that started in 1967 and went all the way to the Supreme Court. The Starker v the IRS case was finally settled in 1979. Mr. Starker changed the rules. The IRS now allows the closing for the relinquished property to occur before the replacement property is identified.
1. Missing deadlines.
2. No plan 'B'.
3. Discomfort from dealing with a complex and time sensitive transaction.
4. Related parties including the agent and client.
5. Potential for fraud.
6. State laws.
If you sell a residence in a 1031 exchange that you have lived in for 2 of the last 5 years before it was sold, and reclassify the property as a primary residence, you could exclude $250,000 (single person) or $500,000 (married couple) of the gain.
With a little planning you can make your money go a lot farther!