The 1031 Exchange is named after the Internal Revenue Code (IRC) Section 1031. Generally, short-term capital gains are taxed as ordinary income according to federal income tax brackets. The long-term capital gains tax rate in 2020 is 15% for the bracket between $53,601 and $469,050, and 20% for $460,050 or more. Under section 1031, an investor enjoys capital gains tax deferral by a like-kind exchange of real estate properties for the purpose of business and investment. There are many incorrect presumptive ideas among investors around the questions like how to swap two properties, what is categorized as like-kind exchange properties or in what order the properties must be exchanged or identified.
Misunderstanding 1: apple for apple type exchange.
This is directly related to the essential definition of what like-kind properties are. In short, an investor does not need to swap a property of an apartment with another apartment. Like-kind properties actually cover an extensively wide range of properties. By definition, the properties have to be of the same nature or character but can differ in grade or quality. It first means that the properties must be real estate. Stocks, bonds, notes, securities, and interest in partnerships are excluded. Historically, prior to December 31 2017, tangible or intangible properties were permitted under the 1031 Exchange. As a result, it used to include aircraft, automobiles, heavy equipment, and mineral rights. But that rule has been abolished after 2017. Second, as an example of the same nature or character, an office building for investment purposes can be exchanged with a gym enterprise.
Misunderstanding 2: a primary residence for another commercial property.
The whole purpose of creating the 1031 Exchange is to propel the economy by encouraging business investments. Hence, properties involved in the Exchange must be bought and sold for investment or business purposes only. Hence, in principle, rental property is qualified but not your personal primary home. It is set to prevent someone from moving his or her primary residence among states via the 1031 Exchange in order to avoid paying capital gains tax. Furthermore, section 1031(a)(2) also stipulates that the 1031 Exchange does not apply to any exchange of real property held primarily for sale. It means that if someone aims to flip a property within a very short period, such a property would not be characterised as business investments, which is one of the necessary qualifications of the 1031 Exchange.
Misunderstanding 3: One must be a US resident.
The law does not require the 1031 Exchanger to be a US resident. However, the exchanged properties must be located in the United States. It is worth noting that a foreign investor might escape from paying the capital gains tax, but his financial transaction could be subject to Foreign Investment in Real Property Tax Act of 1980. It could mean that other types of tax might be levied by the US government.
Misunderstanding 4: the value of the exchanged properties must be equal, and only the property’s value will be counted in the equation.
The value of the property you purchased can be more than the one you sold for the Exchange, but at least the same. Because the aim of the 1031 Exchange is to incentivize investments, the associated cost for the new property purchased can be counted as the value of the purchased property, such as inspection and broker fee.
Misunderstanding 4: one sold for one bought.
The quantity of properties involved in the Exchange is not crucial. If an investor decides to combine the value of multiple identified properties for the Exchange of his or her original property, the 200% Rule will apply. It means that such aggregate value shall not be more than twice the amount of the price of the original property for the benefit of the tax deferral.
Misunderstanding 5: like-kind property covered under the 1031 Exchange is only determined by the nature and character of the property.
Apart from the nature and character of the property, two time windows must be strictly observed. Any property received by the investor would not be treated as like-kind property if such property is not identified as like-kind property within 45 days since the date on which the taxpayer transfers the property relinquished in the Exchange. In other words, within the duration of 45 calendar days, since the property owner sold the original property, he must correctly identify potential like-kind properties. Moreover, the status of like-kind property would not be established if the identified property is received outside the 180-day window starting on the date which the taxpayer transfers the property relinquished in the Exchange. It means that the identified property or properties must be purchased within 180 days for the purpose of the 1031 Exchange.
Misunderstanding 6: multiple investors involved, but each can only play one part of the transaction instead of going through the entire exchange process.
The law requires that the tax return and the title holder must be consistent among all the properties that are involved in the Exchange.
Misunderstanding 7: leasehold interest cannot be qualified for the 1031 Exchange.
Intuitively, it seems to be in line with the real property requirement. However, the law provides an exception for leasehold interest. The rationale behind it could be that for a long lease, such as 30 years or more, the leasee actually could have real rights upon the property or land that is the subject of the lease. To be considered under this exception, there are a couple of tests that must be passed. First, the time. A taxpayer who is not a dealer in real estate exchanges a leasehold of a fee with 30 years or more to run for real estate can be categorised as “like-kind” property. In the case of R & J Furniture Co. v Commissioner, the Tax Court of the United States held that a lease with an initial term of 5 years and ten renewal options of 5 years each was the property of a like-kind and the equivalent of a fee interest in real estate. The lease was deemed under the regulations because the taxpayers had the right to possess, occupy, and use the leased property for a total of 55 years. The second test is whether the leasehold interest is derived from real property or personal property because only the real estate is covered by the 1031 Exchange. The case of Peabody Natural Resources Company v Commissioner is a great example to show how the court deals with this test.
Hope these detailed explanations on several most common misunderstandings on the 1031 Exchange could help you make better-informed investment decisions.