What Is a Section 1031 Like-kind Exchange?
By: Financial Hotline
Spring 2023 (Vol. 41, No. 1)
Named after Section 1031 of the Internal Revenue Code (IRC), a like-kind exchange generally applies to real estate. It is designed for people who want to exchange properties of and defer the taxes. If you own land in Oregon and trade it for a shopping center in Rhode Island, as long as the values of the two properties are equal or greater, nobody pays capital gains tax even if both properties may have appreciated since they were originally purchased.
Section 1031 is not for personal use and is currently limited to exchanges of real property. However, you don’t have to do an equal exchange. You can sell a property at a profit, buy a more expensive one, and defer the tax indefinitely. You can swap an apartment building for a shopping center or a piece of undeveloped, raw land for an office or building. You can even swap a second home that you rent out for a parking lot. It’s possible to roll over the gain from your investment swaps for many years and avoid paying capital gains tax until a property is finally sold. Keep in mind, however, that gain is deferred, not eliminated. You must calculate and keep track of your basis in the new property you acquired in the exchange.
A Section 1031 transaction takes pre-planning. You can’t just sell a property and then decide to do an exchange. You will need to declare your intent from day one, when you first list the property. The IRS requires all funds to go through a qualified intermediary. That means you can’t take a deposit or any proceeds into your own hands. Most investors accomplish this easily by finding a realtor or title agent with experience in this area. The qualified intermediary takes the funds from the sale and holds them until you are ready to purchase the replacement property. You must identify your replacement property within 45 days of your sale. Then you must close on that within 180 days. There is no grace period. If your closing gets delayed by a storm or other unforeseen circumstances, and you cannot close in time, you’re back to a taxable sale.
Section 1031 exchanges may be used for swapping vacation homes but present a trickier situation. Here’s an example of how this might work: Let’s say you stop going to your condo at the ski resort and instead rent it out to a bona fide tenant for 12 months. In doing so, you’ve effectively converted the condo to an investment property, which you can then swap for another property utilizing the 1031 exchange. There’s a catch if you want to use your new property as a vacation home. You’ll need to comply with a 2008 IRS safe harbor rule in each of the 12-month periods following the 1031 exchange; you must consecutively rent the dwelling to someone for 14 days (or more). In addition, you cannot use the dwelling for more than the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented out at fair rental price.
You must report a Section 1031 exchange to the IRS on Form 8824, Like-Kind Exchanges, and file it with your tax return for the year in which the exchange occurred. If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.
Q: What is the difference between an Opportunity Zone purchase and a 1031 Exchange?
A: The tax planning advantages of both Qualified Opportunity Zones (QOZ) and 1031 exchanges are similar. They both allow investors to defer recognition of a gain on the sale of an investment or property. One big difference comes with the deferral time frame. While 1031 exchanges don’t have deadlines, QOZs allow for the deferral of tax on the gain until either the sale of the property or December 31, 2026, whichever comes first. (Congress may vote this year to extend this deadline) The 1031 exchange currently only allows you to defer gain from sale of real estate whereas the QOZ program allows you to defer gain from the sale of any type of asset – real estate, stocks, bonds, etc.
Also, with a 1031 exchange, there’s a full pay day someday. If you decide not to keep exchanging, you will owe tax on the full amount of the deferred gain. By contrast, with QOZs, if the investment is held for more than five years, 10% of the gain can be excluded, meaning that only 90% of the final capital gain would be taxed. If held for seven years, the exclusion ticks up to 15%. If the QOZ investment is held for at least 10 years, the investor can receive stepped-up basis on the investment. When the investment is eventually sold, the basis (or amount of original investment) is increased to the fair market value at the time of the sale. Since taxpayers are taxed on the capital gain, or difference between their basis and the sale price, this effectively makes the transaction tax-free. This does not exist with 1031 exchanges.
With 1031 exchanges, replacement properties can be purchased in any location with no geographical restrictions. With QOZs, investments must be made by Qualified Opportunity Funds into Qualified Opportunity Zones, which are government-designated distressed communities across the country. Only properties in these areas qualify for the tax-deferred/tax-free treatment. You can find a QOZ map at opportunityzones.hud.gov/resources/map
Q: Can I purchase investments like real estate, businesses, or gold through my IRA?
A: Yes. A self-directed IRA (SDIRA) is fundamentally the same tax-advantage account you may find at any brokerage firm, custodian, or bank. Your self-directed account can be Traditional or Roth and the contribution and withdrawal restrictions are the same. The difference with a self-directed IRA is that it enables you to invest in a wider range of alternative assets, such as real estate, promissory notes, crypto, gold bars and private equity.
To start or switch to a self-directed IRA, you will need to select a financial firm and custodian that’s specially equipped to handle the accounts’ administrative requirements. Examples include Equity Trust Company, Broad Financial and Madison Trust, Inc. You can fund your account via rollover, transfer, or out-of-pocket contribution. Once your funds are available, you are in control of purchasing the investments and the custodian’s duties include providing the funds and holding the assets.
There isn’t a big difference in how you buy investments, you are just directing your custodian to provide the funds. For example, if you use your IRA funds to purchase real estate, you would simply make an offer listing the purchaser as “Equity Trust Company for the benefit of John Doe IRA” then direct your custodian where to send the deposit or closing funds.
Choosing the best custodian will depend on what type of investment you are making. For example, a firm like American Heritage specializes in IRAs for precious metals and can help you manage the paperwork and tax reporting for your gold transactions to meet the IRS requirements for retirement planning. The IRS does not allow you to personally store precious metals owned via a gold IRA at home. Gold IRA rules mandate that you store eligible precious metal with a national depository, a bank or a third-party trustee approved by the IRS.
IRS tax code defines retirement plans and The Employee Retirement Income Security Act (ERISA) of 1974 outlines rules and tax implications of transactions within qualified plans.