1. A 1031 cannot be used for personal use.
The 1031 exchange is only for investment and business property, so you cannot trade or swap your primary residence for another house. There are ways you can use a 1031 for swapping vacation homes, but this loophole is much narrower than it used to be. For more details, see #10.
2. Personal property no longer qualifies.
Under the new law, only real estate qualifies for an exchange. Before the new tax law on Dec. 22, 2017, some exchanges of personal property – such as franchise licenses, aircraft, and equipment – qualified for a 1031 exchange. If you own real estate as Tenants in Common- your interest may be exchanged.
3. A special transition rule might help.
The TCJA (Tax Cuts and Jobs Act) includes a transition rule that permits a 1031 exchange of qualified personal property in 2018 if the original property was sold or the replacement property acquired by Dec. 31, 2017. The transition rule is specific to the taxpayer and does not permit a reverse 1031 exchange in which the new property is purchased before the old property is sold. This one I defer to your accountant!
4. “Like-kind” -What does that mean?.
Exchanges must be of “like-kind” – but what does that mean? You can actually exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. Again, always consult your accountant.
5. Delayed Exchanges.
Typically, an exchange involves a swap of one property for another between two people. However, the odds of finding someone with the exact property you want who wants the exact property you have are almost nil. For that reason, the majority of exchanges are delayed, third-party or “Starker” exchanges (named for the first tax case that allowed them). In a delayed exchange, you need a Qualified Intermediary (middleman) who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. This third-party exchange is treated as a swap.
6. You must designate replacement property.
There are two essential timing rules you must observe in a delayed exchange. First, you must designate the replacement property to be exchanged. Once the sale of your property occurs, the intermediary will receive the cash. You can’t receive the cash, or it will negate the 1031 treatment. Also, within 45 days of the sale of your property, you must designate replacement property in writing to the intermediary, specifying the property you want to purchase. The IRS says you can designate three properties so long as you eventually close on one of them. NOTE: If the taxpayer wants to identify more than three properties, he can use the 200% rule. This rule says that the taxpayer can identify any number of replacement properties, as long as the total fair market value of what he identifies is not greater than 200% of the fair market value of what was sold as relinquished property.
7. Six Months to close!
The second timing rule in a delayed exchange relates to time close. You must close on the new property within 180 days of the sale of the relinquished property. The two time periods run concurrently. That means you start counting when the sale of your property closes. If you designate replacement property precisely 45 days later, you’ll only have 135 days left to close on the replacement property.
8. Don’t get Booted!
If the replacement properties cost less than the relinquished property, you will have to pay tax on the difference. If so, the intermediary will pay it to you at the end of the 180 days, and the tax will most likely be considered a capital gain.
9. Don’t let the mortgages cost you $$$
One of the primary ways people get into trouble with these transactions is failing to consider mortgages. You must consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property. If you don’t receive cash back, but your liability goes down– that, too, will be treated as income to you, just like cash. Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. You have $100,000 of gain that is also classified as “boot,” and it will be taxed.
10. Using 1031 for a vacation home is confusing.
You can sell your primary residence and, combined with your spouse, shield $500,000 in capital gain, so long as you’ve lived there for two years out of the past five. However, this break isn’t a 1031, and it isn’t available for your second or vacation home. You might have heard tales of taxpayers who used a 1031 to swap one vacation home for another, perhaps even for a house where they want to retire. The 1031 delayed any recognition of gain. Later, they moved into the new property, made it their primary residence and eventually planned to use the $500,000 capital-gain exclusion.
In 2004, Congress tightened that loophole. Yes, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Example: You stop using your beach house, rent it out for six months or a year, and then exchange it for other real estate. If you get a tenant and conduct yourself in a businesslike way, you’ve probably converted the house to investment property, which should make your 1031 exchange OK. However, if you merely hold it out for rent but never actually have tenants, it’s probably not allowable. The facts will be crucial, as will the timing. The more time that elapses after you convert the property’s use to rental the better. Although there is no absolute standard, anything less than six months of bona fide rental use is probably not enough. A year would be better.
If you want to use the property you swapped for as your new second or even primary home, you can’t move in right away. In 2008 the IRS set forth a safe harbor rule, under which it said it would not challenge whether a replacement dwelling qualified as investment property for purposes of a 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange: (1) you must rent the dwelling unit to another person for a fair rental for 14 days or more; and (2) your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
Moreover, after successfully swapping one vacation/investment property for another, you can’t immediately convert the new property to your primary home and take advantage of the $500,000 exclusion. Before the law was changed in 2004, an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence. Now, if you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange. In other words, you’ll have to wait a lot longer to use the primary-residence capital-gains tax break.
Credit: Robert Wood