Get Ready For The Changes in 1031 Exchanges
By Nace Cohen, CPA
President, 1031 Exchange Connection in Naples, Florida
Here we go again, round two of the great Exchange. We all remember what was going on in the world of real estate a few years back. It was simple, buy low and sell high, with one drawback – the capital gains tax. The solution was easy, do a 1031 Exchange! Well it’s back and for good reason. These days, foreclosures and short sales drive the market in closed sales. Investors are acquiring so low that gains to be made are just around the corner, and they plan on taking advantage by selling for a quick profit and exchanging into more. Is a 1031 that easy? It used to be, however significant changes were made to the code and need to be addressed so you are ready should the IRS want to look at your exchange.
Section 1031 joins together the sale of old “Investment” property with the purchase of new by rolling the gain forward to the new property. The tax that would have been paid gets deferred into the future, a wealth building technique commonly used by real estate investors. There are strict rules to follow regarding property type, timing, title and taxability.
The first thing the IRS will look at is the type of properties exchanged. Both the Old and New properties must qualify as investment or business use. Land always qualifies, as does rental property. Not clearly defined in section 1031 is how long you must hold the property before exchanging it. A new ruling, Rev. Proc. 2008-16, provides a safe harbor for exchanging residential properties and now requires a holding period of two (2) years. The old “year and a day” rule no longer applies. Also, you must rent the property for a minimum of 14 days and cannot use it more than 14 days a year in each of those 2 years. So, if you're thinking of buying a foreclosure, short sale or fixer-upper, and flipping it in less than a year, consult with your tax accountant before doing an exchange.
Another change concerns a tax free strategy commonly used by exchangers when they wanted to retire into property they exchanged into. For example, let’s say you sold land in 2005 and exchanged into a nice Naples condo you wanted to live in someday, but in order to comply with the rules of 1031 you needed to rent it first. You rented it for 2 years, then sold your home up north and moved into the condo. When you sold your old home, you took that gain tax free because under the principal residence exclusion, you can exclude gain up to $500,000 since you are married and lived in the home for at least 2 out of 5 years as a principal residence. Now all you need to do is live in that new condo for 2 years, sell it, and the gain is again tax free since it was your principal residence when you sold it, right? And the gain that was rolled into it from the sale of the land get’s eliminated through the home sale. Super!
Well it used it be that way, and it was a great strategy, that is until the IRS revised it. The IRS says you can still do it, but two (2) things need to occur before you can eliminate any of the gain from tax. First, if you buy a property in a 1031 and later sell it as a principal residence in an attempt to eliminate the gain through the home sale exclusion, you need to hold the property for a full five (5) years before you sell it. This 5 year holding rule only applies if the property you’re selling was purchased in a 1031 exchange. If it wasn’t, then you only need to hold it for 2 years to get the exclusion.
Second, if you sell that 1031 condo, the gain needs to be prorated between the time you held it as investment and personal. Only the personal gain is eliminated through the home sale exclusion, and the investment portion is taxed. For example, in our land/condo example, if you sold that condo at a $500,000 gain, including the rollover gain from the land, and you rented it for 2 years and lived in it for 3 years after, then 2/5 of the gain, or $200,000 is taxable as investment, and 3/5 is tax free. If you live there for 8 years after the 2 year rental period (total 10 years owned), then 2/10 of the gain would be taxed and 8/10 excluded. Therefore, the longer you live there, the less is taxed.
The tax trap here is if the condo was sold before year 5 and you were living there, then the entire gain is taxed! Many investors are falling into it because they rented it for 2 years, then lived in it for 2 more years, or a total of 4 years owned, then selling it thinking they can take the gain tax free since they attained the 2 year principal residence timeframe. However, since they did not own it the full 5 years as now required, it doesn’t qualify as a principal residence or a 1031 as it was personal use at the time of the sale. This is very confusing and a tax professional well versed in real estate taxation should be consulted when shuffling between personal and 1031 properties.
The changes cited above are the most significant that affect 1031 exchanges these past 2 years. Planning your exchange requires more care now to ascertain whether your investment and retirement objectives can be met. But the benefits of building wealth through 1031 exchanges are still bountiful and should not be dismissed because of the new hoops created by the IRS. They are merely saying if you’re going to do 1031 exchanges, better make sure you do them right and document what you are doing along the way.
Nace Cohen is the President and founder of 1031 Exchange Connection, Inc., an IRC §1031 exchange consultancy based in Naples, FL. He lectures extensively on IRC §1031, consults and structures tax deferred exchanges for Real Estate and Personal Property Exchanges, and provides replacement property alternatives . He is also a CPA and operates an accounting and tax practice specialized in real estate taxation and property management. Call toll-free 888-659-1031 for a free consultation, or visit their web site at www.1031-connection.com.