|
Once the province of commercial brokers, Internal Revenue Code
section 1031 exchanges are increasingly being used by savvy
residential investors to defer capital-gains taxes. Most people
know the basics of a 1031, or like-kind, exchange: For a
property you plan to sell, you have to identify replacement
property within 45 days and close on the purchase within 180
days. Beyond that a lot of misinformation exists. Understanding
these common misconceptions will help keep you
out of trouble.
Myth No. 1: The 180-day rule can be extended if Day 180
falls on a weekend or a holiday.
Like-kind exchanges must close no later than day 180 after the
deed transfer date of the relinquished property. Closing in
escrow doesn’t count. There must be actual transfer of
ownership. The U.S. Tax Court has reaffirmed it: If your
client’s 180 days are up on Sunday, you can’t close on Monday;
you have to close on the preceding Friday. The no-exception date
rule also applies to the 45 days given to identify a property
for exchange.
Myth No. 2: Residential properties transferred through a
1031 exchange must be used exclusively as rentals.
You can acquire a second home or vacation home with 1031 funds
for personal use as long as you follow certain guidelines.
First, the property needs to be placed in a rental pool and
offered for rent at market rate. The exchanger can use the
property for up to 14 days per year or 10 percent of the time
the property is rented, whichever is greater. In addition, if
the exchanger needs to perform maintenance on the property, the
exchanger can stay in the property while that work is done.
Myth No. 3: Only developed properties qualify for
like-kind exchanges.
Most people believe 1031 exchanges are limited to developed land
and “sticks and bricks.” But vacant land also qualifies. For
instance, you can exchange an apartment building for vacant
land. In addition, properties or land can be exchanged for
anything else defined under a state’s law as real estate. For
example, in Colorado, the state’s definition of real estate
includes not only improved and vacant land, but also water
rights, mineral rights, air rights, a leasehold interest in
excess of 30 years, and even a contract to buy or sell real
estate. A caution: Definitions of real estate vary from state to
state, so be certain an asset is eligible as real estate before
making an exchange.
Myth No. 4: Exchangers must purchase replacement
properties that are equal in value to the property they’re
exchanging.
There’s no limit to the value of the property an exchanger can
buy as long as the exchanger identifies no more than three
properties as possible replacement. For example, if an exchanger
sold one property for $500,000, the exchanger could identify $10
million of replacement property. However, the minute exchangers
identify more than three properties, the exchange falls under
the 200 percent rule, which states that the properties can have
an aggregate value of no more than 200 percent of the property
they’re replacing.
Fail to meet the 200 percent test, and the exchange falls under
the 95 percent rule. Under this provision, exchangers must be
able to close purchases on properties with a total value of at
least 95 percent of the value of the property they’re selling or
the exchange will be disallowed by the IRS. Value is defined by
the IRS as either the contract price or an appraised fair market
value.
Myth No. 5: Your attorney or your real estate
professional can act as the qualified intermediary who takes
temporary title to the property for your exchange.
The Internal Revenue Code describes who can’t be a qualified
intermediary. The client’s attorney can’t serve as a QI if
there’s been an attorney-client relationship over the preceding
two years, nor can the client’s CPA if he or she has prepared
the client’s tax return within the last two years. A real estate
licensee representing any party in the exchange is also excluded
because of the agency relationship. To further confuse matters,
there are no statutory requirements as to what constitutes a QI
or the qualifications for becoming one.
Myth No. 6: When you exchange property via a 1031
exchange, you defer all tax liability.
Any cash not spent on the purchase of a replacement property
during an exchange, called boot, is fully taxable, regardless of
the client’s adjusted basis on the property. This boot is taxed
at federal capital gains tax rates (currently 15 percent). In
addition, exchangers may owe capital gains taxes in the state in
which the property is located. If exchangers depreciated the
relinquished property for tax purposes after May 1997, they may
also have to pay a recapture tax of 25 percent on any boot they
receive.
Myth No. 7: A taxpayer can’t complete a 1031 transaction
with a related party.
Clients can use a 1031 exchange to buy property from or sell
property to a related party, but the related party must then own
that property for at least two years before selling or
exchanging it. Otherwise the exchange is invalidated and the
client may owe capital gains taxes. Under IRS rules, parents,
spouses, siblings, and children—essentially any parties related
by blood—are considered related parties.
The intricacies of exchanges are best handled by a team that
includes an accommodator, a real estate broker, and attorney or
CPA. Assemble that team before the you put the property on the market. Otherwise, you run the risk of an
error that could invalidate an exchange. |
