Sounds unbelievable, doesn’t it?
It’s enough to fire up the imagination (and put those little cartoon-character “dollar signs” in the eyes) of any real estate investor: the thought of making investments and never having to take a capital gains hit on them. But is it for real? Can you truly invest in properties and pay no capital gains tax when you sell them?
Yes. (With some caveats.)
The magic clause? Section 1031 of the Internal Revenue Tax Code. It’s among the most powerful tax-deferral strategies you can employ. In very real terms, it can enable you not to have to pay capital gains tax on the sale of your properties, provided the sales proceeds are reinvested in similar or like kind property.
Piece of cake. Right?
It depends. If you’re an active real estate investor and have set up your investments in business entities, Section 1031 has a couple of important provisions that could make your life more complicated. To extend the metaphor, use the wrong “recipe” and you could “bake up” a disaster.
How to keep your “sweet” ending from turning sour? Follow the rules.
And here they are:
1. The Property You Sell MUST Be Held for Investment or Used In Your Trade or Business.
This is pretty straightforward. It means property of all sorts, including real estate, improved or unimproved, held for investment or income-producing purposes:
- residential or commercial property
- raw land
- fractional or leasehold interests
- water or mineral rights
- oil and gas interests
…even development rights.
The same goes for your business: this covers real estate, properties, and equipment used in conducting your normal “trade.”
2. The Replacement Property Must Be Like Kind.
Yes, this is a key ingredient — but it’s not as stringent as many investors mistakenly believe. You don’t necessarily need to exclude certain properties from the exchange because they’re not “like” — the determining factor is intent, not physical similarity. In other words, if the property you’re selling was held for investment, then you need to intend to do the same with the property you’re buying. But that doesn’t mean they need to be exactly alike. This means…
- You can replace an apartment building with raw land, or vice-versa.
- You can exchange one rental property for two or more properties, or vice-versa.
N.B.: Pay attention to these EXCEPTIONS:
1) properties held as primary or secondary residences – unless you use this technique discussed in a previous blog “Selling your Residence Tax-Free“
2) land held for subdivision and sale
3) fix-ups and “flips”
These are not eligible for Section 1031 treatments. That means that, even though many of us refer to a second or vacation home as an “investment,” don’t be fooled: it doesn’t fit the IRS definition of that term for Section 1031 purposes.
3. The Replacement Property Title Must Be Taken (and Titled) in the Same Name as the Relinquished Property.
If the property you sell is titled in your name, as an individual, the replacement property must be titled in your name, too. This can be tricky if you want your LLC or other business entity to own the new property — but it’s a fairly simple procedure to make happen. After you take title in your name, if there is no change in beneficial ownership, you can later transfer the property into a land trust or LLC.
How much later?
Well, most CPAs recommend you wait for the new tax year. However, if the entity you’re using is disregarded for tax purposes, I don’t believe that you are required to wait; after all, the entity isn’t part of the income tax picture for you.
Of course, the same thing holds true if the title is held by a land trust, corporation, LLC, or other entity, you need to title the replacement property in its name.
That Sticky “Personal” Titling Requirement
Remember how we talked about some provisions of this law that can sneak up on you if you’re not prepared for them? The above rule is a primary sticking point for many investors who currently own property in a land trust or LLC, but who want to use financing to secure replacement residential property. There’s only one problem with that plan: it won’t work.
Financing the acquisition of residential real estate requires that you take title in your personal name, as an individual — a requirement that can set up the distasteful scenario of your arriving at closing only to discover your lender will refuse to close in the entity. You’ve violated the third rule of Section 1031, and your exchange blows up in your face.
Sidestep the Explosion!
Want to avoid that mess and headache? Don’t despair — there is a way.
If you want to enter into an exchange with property held in an entity, and you plan on acquiring residential real estate with the exchange proceeds, then here’s what I recommend: deed the property into your personal name prior to listing it for sale.
This is a good strategy to adopt even if you don’t plan to use financing to acquire the replacement property. It’s a tactic that keeps you operating within the rules and keeps your options open as well. Then, after the exchange is final, you can simply transfer the property back into your entity.
Property Held in an Entity with Other Partners
What about when you’ve invested in property with several other people? When it’s time to sell, often one or more of your investment partners will want cash, not a rollover into another property. If this sounds like it could present problems, you’re right — and no insignificant tax risk.
What’s the Way Out?
Think in terms of an “individual” approach.
You can preserve your exchange options by having the individual partners deed the property out of the partnership and into individuals’ names prior to putting it up for sale. What you end up with is a distribution of the property from the partnership to the partners themselves, who then hold the property as tenants in common. This then positions each individual to sell or exchange his tenancy — a process that folks familiar with 1031 exchanges refer to as a “drop and swap.”
Avoid Potential Tax Traps with a Little Forward Thinking
No matter your investment situation, it will pay you — literally and figuratively — to plan transactions carefully, and in advance. Many a trap awaits an investor who tries to move too fast or “shortcut” his way around regulations. Don’t fall into those traps; call us and let us help you make your transactions safe, “goof-proof” — and profitable!