1031 Exchange for Residential Properties
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1031 exchanges, are also known as "Deferred exchanges" or a "Starker exchange". These exchanges do not avoid taxes but can defer them as long as certain criteria and time frames are met.
What types of residential properties qualify?
Property must be an investment property, not your primary residence or second home. If it was your primary residence, you have to convert it to a rental property for at least two years before it will qualify for a 1031 exchange. A vacation home has to be rented out for at least six months to a year before it can qualify. And, it should truly be rented. You can't just say you tried to rent it.
Minimum time frames must be met. An owner occupied residence must be rented for two years to qualify for a 1031. A residential rental property may qualify if you've owned and rented it for at least six months. Some accountants advise owning and renting for a "year and a day".
Vacation rentals such as condo-hotels can be bought and sold through a 1031 exchange. When property is rented on a short term basis, the owner is not allowed to occupy it more than 2 weeks per year or more than 10% of the time rented. For example, if the property was only rented 30 days over the past year, you would not be able to use it more than 3 days. If it's rented 100 days, you can stay there 10 days.
Not all investment properties qualify. The IRS prohibits using a 1031 on "property held primarily for sale". If you flip homes or build spec homes, you will need to consult with a tax accountant/real estate attorney. It's rare but they may be able to help you structure an LLC which will allow you to use 1031 exchanges.
How Does a 1031 Exchange Work?
The 1031 exchange was originally designed to allow farmers to exchange parcels of farmland. The trades were simultaneous and no capital gains taxes were due. Today we can sell an investment property and replace it without having to pay capital gains taxes right away. In order to qualify, these basic procedures must be followed:
Start by Finding a Qualified Intermediary (QI). They are sometimes called an accommodator or facilitator. As Ginny Lacey Gorman points out, "a qualified intermediary must be involved". Since 1031 Exchanges impact Federal taxes, this is true in every State. However, different States do have different regulations for QIs.
The intermediary must be in place before close of escrow. They will receive the funds from the sale of the property being exchanged. It is extremely important that the seller never receives proceeds from the sale. The QI has to accept them and keep them in an approved account until they're used to purchase the replacement properties.
You need to use extreme care in choosing your intermediary. At the peak of the housing market, an Accomodator that was headquartered in Nevada became the subject of scandal. The scandal led to criminal investigations. It's easy to find the details by googling "Southwest 1031". Unfortunately, over a hundred people lost tens of millions.
Nevada now has stricter regulations for QIs. In Nevada, the QI must be licensed. They must post a $1 Million Bond and carry $250,000 E & O Insurance. An FBI Background check is required and the State can audit them. The State also requires Qualified Intermediaries to use Qualified Escrow or Qualified Trust Accounts.
More important, the Exchanger (Seller or Buyer in a Reverse Exchange) must sign off on all transfers of funds out of the account. The QI and escrow holder must also sign off on all transfers. Hopefully, these safeguards will prevent another Southwest.
Do your due diligence when choosing your Qualified Intermediary. Find out if they're affiliated with a larger company that has significant assets. Do they offer training or seminars to help you understand 1031 exchanges and the role they will play. Ask your Escrow Officer who the Title Company recommends.
The Three Rules For Identifying Your Replacement Properties.
A 1031 exchange can be quite simple, if you follow the time frames.
Appoint the Qualified Intermediary before close of escrow.
Identify the replacement properties before midnight on the 45th day after closing.
Close escrow on the replacement property within 180 days.
Miss any of these time frames and you will owe taxes. These time frames make it risky to include a short sale or distressed property as one of your replacement properties. Make sure that the seller can and will close within the 1031 time frame.
For more information, read Joe Manausa's "The Basics of a 1031 Exchange".
Three Options For Identifying the Replacement Property.
The Three Property Rule - This is the most common type of exchange. Identify three possible replacement properties. You must identify them in writing before midnight on the 45th day after closing. You have to purchase one of the properties within 180 days from the close of escrow on the original.
You can close on the replacement property before the 45 day period has passed. This is the safest way to ensure that you meet the IRS guidelines. When purchasing a home in today's market, appraisal issues and other factors can arise. Get into contract as quickly as possible. You will have more time to deal with issues that may arise on the replacement property.
The 200% Rule - This rule allows you to identify more than three properties. Their combined total value cannot exceed more than 200% of the value of the property being sold. This rule doesn't work as well with residential properties as it does with commercial. If you are selling a single family home for $200K, you would only be able to identify $400K in replacement properties.
The 95% Rule - The 95% rule allows you to identify as many properties as you choose, but you must close on 95% of them. Stephen Decker, VP of IPX1031 recently discussed this at a luncheon in Las Vegas. As Stephen said, this one seldom works. It may be easy to identify all the properties, but closing on 95% of them could be a challenge.
How much do you have to re-invest on the replacement property?
To defer all taxes due on the sold property, you have to re-invest the full amount received. This amount includes any debt that was carried on the property. If you had a mortgage on the property sold, you need an equal or greater mortgage on the replacement property. If there is no mortgage on the replacement property, the IRS will view the paid mortgage as "debt relief" and it will be taxable.
In a 1031 exchange, you will hear about the "boot". The Boot is the amount, if any, that is left over after the replacement property is purchased. The ideal 1031 exchange has no boot.
You purchase a home for X. You sell it for X + Y. You pay a minimum of X + Y for the new home.
If you carried a mortgage of Z, you take out an equal mortgage on the new property.
You can pay more for the replacement property than you receive for the sold property. If you pay less for the replacement, the difference will be subject to capital taxes. If the mortgage on the new property is less than the mortgage on the sold property, the difference will be subject to taxes.
The ideal scenario is to buy a residential investment property for $200K with a $160K mortgage. Sell it a few years later for $400K with the mortgage paid down to $125K. Buy a replacement property for $400K and finance $125K. If all other conditions are met, this will defer taxes.
Reverse 1031 Exchange - You Can Buy the Replacement Property First!
If you're driving down the street and see a property for sale that is perfect for your investment needs, make an offer on it. Review your other investment properties. Do you have any that are not producing the cash flow they once did? Do you have one that is getting older and may start needing more maintenance? Do you have one with a tenant who has let you know they're now in a position to buy?
If the answer is yes, you should consider doing a "Reverse 1031 Exchange". A reverse 1031 exchange sounds complicated but it can be very simple if you meet the timeframes and requirements.
Step 1 - Establish a relationship with an "Exchange Accommodation Titleholder" (EAT). The "EAT" is similar to the Qualified Intermediary in that they must be appointed before close of escrow. Choose carefully. They will hold Title to your property while you sell the relinquished property.
You will fund the purchase of the replacement property with cash, a mortgage or some combination. The EAT will take Title to the property and hold it until the relinquished property is sold.
Step 2 - Identify and sell the "relinquished property". As with a standard 1031 exchange, you have up to 6 months to find a buyer for the relinquished property. The timeframe means a Reverse exchange is much easier if you have a buyer lined up for the relinquished property early on.
1031 Exchanges Simplified
1031 exchanges can be a valuable tool to defer taxes until the time when you're ready to transition out of some real estate holdings.
In order to do them successfully, you have to adhere to the timelines and you must never touch the proceeds from the sale. Any cash that you touch will become taxable.
The last several years have seen a high number of homes sold to investors. We expect many of these investors will use 1031 exchanges as they sell these investments over coming years. Discuss the benefits of a 1031 with your accountant before selling.
Planning to buy or sell a residential investment in Las Vegas? Call (702)354-6900 or email [email protected] Planning to buy or sell a residential investment in another area? We'll be happy to help you find a Realtor with 1031 experience.