If you’re a serious real estate investor, you probably know about tax-deferred Section 1031 exchanges, AKA like-kind exchanges. They allow you to swap appreciated real property for other real property without paying any federal income tax.
While real estate values are still surging in many areas, you may hold appreciated property that you think has topped out and are now looking at what you think are greener pastures. But an outright sale of appreciated property would result in a current income tax hit — maybe a big one. That’s a suboptimal outcome if you intend to use the sales proceeds to buy replacement property.
What to do? Section 1031 exchange to the rescue. Let’s discuss, starting off with a couple of updates. Here goes.
An unfavorable Biden tax proposal is off the table for now
President Biden’s menu of proposed tax increases would have greatly limited the Section 1031 exchange privilege, but it now appears that unfavorable change will not happen anytime soon. That’s a positive non-development. Still, you never know what’s going to happen, so doing 1031 exchanges sooner rather than later is probably prudent.
Favorable IRS regulations
In other favorable news, the IRS recently issued final regulations that define what constitutes real property for Section 1031 exchange eligibility purposes. Basically, if you swap one asset that the regulations classify as real property for any other asset that’s also classified as real property, the swap can qualify for tax-saving Section 1031 exchange treatment.
The regulations define real property to include ownership interests in land; improvements to land, such as permanent structures; unsevered natural products of land, such as crops and mineral deposits; and water and air space “superjacent” to land, such as a marina. Superjacent means overlying. I had to look that up too!
If interconnected assets work together to serve a permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets can qualify as a structural component of real property. For example, a gas line that fuels a building’s heating system counts as real property.
Personal property is considered incidental to real property if: (1) the personal property is typically transferred together with the related real property in commercial transactions, and (2) the aggregate fair market value of the personal property does not exceed 15% of the aggregate fair market value of the property.
Personal property that passes these tests is classified as part and parcel of the associated real property and can therefore be included in a tax-saving Section 1031 exchange. Examples of such personal property include backup power generators, flooring, carpeting, window treatments, and the like. For instance, say you and some partners want to swap raw land for a small hotel worth $20 million. The hotel can have up to $3 million of personal property (15% of $20 million) and still qualify for a Section 1031 exchange.
The regulations also list examples of intangible assets that can count as real property — such as options, leaseholds, easements, and land development rights.
Finally, the regulations stipulate that any property that’s considered real property under applicable state or local law counts as real property for Section 1031 exchange purposes.
Bottom line: the regulations define real property very broadly, which makes it more likely that a property swap that you have in mind will qualify for tax-saving Section 1031 exchange treatment. For instance, you could swap an apartment building for a marina. I don’t say this very often, but thank you IRS.
The impact of ‘boot’
To avoid any current taxable gain on a Section 1031 swap, you must avoid receiving any boot, which means cash and other stuff that’s not classified as real property. When mortgaged properties are involved, boot includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).
If you receive boot, you’re taxed currently on gain equal to the lesser of: (1) the value of the boot or (2) the gain on the transaction based on fair market values. So, if you receive only a small amount of boot, your swap will still be mostly tax-deferred — as opposed to completely tax-deferred. On the other hand, if you receive lots of boot, you could have a big taxable gain.
The easiest way to avoid receiving any boot is to swap a less-valuable property for a more-valuable property. That way, you’ll be paying boot rather than receiving it.
Important: Paying boot won’t trigger a taxable gain on your side of the deal. So, if you want to include cash from bailing out of the stock market with real property that you current own for more expensive replacement property, you can do the deal as a tax-deferred Section 1031 swap.
In any case, the untaxed gain in a Section 1031 swap gets rolled over into the replacement property where it remains untaxed until you sell the replacement property in a taxable transaction.
How do deferred Section 1031 exchanges work?
Realty check: it’s usually difficult, if not impossible, for someone who wants to make a Section 1031 swap to locate another party who owns suitable replacement property and who also wants to make a Section 1031 swap. The saving grace is that a deferred exchange can also qualify for tax-deferred Section 1031 exchange treatment.
Under the deferred exchange rules, you need not make a direct and immediate swap of one property for another. Instead, you can in effect sell the relinquished property for cash, park the sales proceeds with a qualified intermediary who effectively functions as your agent, locate a suitable replacement property later, and then arrange for a tax-free Section 1031 exchange by having the intermediary buy the property on your behalf. Here’s how a typical deferred swap works.
* You transfer the relinquished property (the property you want to swap) to a qualified exchange intermediary. The intermediary’s role is to facilitate a Section 1031 exchange for a fee which is usually based on a sliding scale according to the value of the deal.
* Next the intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.
* The intermediary then uses the cash to buy suitable replacement property which you’ve identified and approved in advance.
* Finally, the intermediary transfers the replacement property to you to complete the Section 1031 exchange.
Voila! From your perspective, this series of transactions counts as a tax-deferred Section 1031 swap. Why? Because you wind up with the replacement property without ever having actually seen the cash that greased the skids for the underlying transactions.
Important: See the SIDEBAR for the deadlines for making a deferred Section 1031 exchange.
What if you still own the replacement property when you die? Under our current federal income tax rules, any taxable gain would be completely washed away thanks to another favorable provision that steps up the tax basis of a deceased person’s property to its date-of-death fair market value. So, under the current rules, taxable gains can be postponed indefinitely with like-kind swaps and then erased if you die while still owning the property. Wow!
Your heirs can then sell the property and owe zero federal income tax or just a little tax based on post-death appreciation, if any. What a deal. Real estate fortunes have been made in this fashion without having to share with Uncle Sam.
Note: A proposal that was included in the Biden tax plan would have greatly reduced the date-of-death basis step-up break. Thankfully, that unfavorable change is apparently off the table for now. If it comes back, we can hope that it will only affect those who are truly rich. Fingers crossed!
What if I have big stock market losses?
You have a bit of a tax dilemma. If you have a big net capital loss from the stock market’s swoon, you can use it to offset capital gain from an outright sale of appreciated real property. But if you use up your capital loss for that purpose, you can’t use it to offset future stock market gains.
On the other hand, if you unload appreciated real property in a Section 1031 exchange, you can avoid a current taxable gain on the property deal and still have the capital loss in your back pocket to offset future stock market gains. But how soon might you have stock market gains? Good question, and there’s no guaranteed right answer. Make you best guess and act accordingly.
The last word
While arranging Section 1031 exchanges can be complicated, the tax savings can be well worth the trouble. Get your tax advisor involved to avoid pitfalls.
Sidebar: Deadlines for deferred Section 1031 swaps
In order for a deferred real property exchange to qualify for tax-free Section 1031 treatment, you must meet two important deadlines.
1. You must unambiguously identify the replacement property before the end of a 45-day identification period. The period commences when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. In fact, that document can list up to three different properties that you would accept as suitable replacement property.
2. You must receive the replacement property before the end of the exchange period, which can be no more than 180 days. Like the identification period, the exchange period also commences when you transfer the relinquished property. The exchange period ends on the earlier of: (1) 180 days after the transfer or (2) the due date (including any extension) of your federal income tax return for the year that includes the transfer date. When your tax return due date would cut the exchange period to less than 180 days, you can extend your return. That restores the full 180-day period.