Dos and Don'ts of a 1031 Exchange
Dear Ali;
I want to sell my current investment property and buy a new one -- Is that a 1031 Exchange? Do you have any tips for that? Can my real estate agent help me do this?
A: Yes, your real estate agent can help you with a 1031 exchange (and, since they'll likely get two commissions, they ought to show you the tips and tricks and be nice about it). However, to do the exchange properly, you'll need a QI (which is more than a great two-letter word in Scrabble).
A little explanation here before I get to specific hints: the 1031 is a tax, er, management strategy. If you've bought low and sold high -- you're either lucky or you're smart, but of course either way you don't want to pay taxes on the difference, which is called your capital gain.
For homeowners, until President Clinton changed the rules, you could avoid capital gains taxes by "rolling up" your capital gain and buying something even more expensive. (Now there's just a flat exemption of $250,000 per person, with certain restrictions).
But what about the poor little investor? (Let's use "poor" ironically, since we're talking about somebody who has made money on a rental property). What was he or she to do?
The answer is located in section 1031 (thus the name) of the tax code. You can avoid capital gains taxes by doing a roll-up, just as you used to be able to do with personal property. However, it's not as simple as selling condo A and buying condo B. For one thing, the IRS doesn't trust you -- or even your real estate agent -- to handle the exchange of A for B. If you do, or your agent does, it's taxable.
So instead the IRS asks you to use a financial ninja, or maybe a better metaphor is a financial crossing guard, to actually deal with the exchange. That person is known as a Qualified Intermediary, or QI.
In addition, the IRS won't let you swap just anything for just anything. So before you sell, you need to identify what you want to buy. There are time restrictions on this, and you have a maximum of 180 days to finish up.
With that little bit of background, if you're considering a 1031,
- DO:
- ...exchange like for like. You can 1031 nearly any investment for a like-kind investment -- stocks for stocks, for instance. But the IRS is pretty strict about what "like-kind" means. Section (e) of the code points out you can't change a bull for a cow (I am not making this up, this is what your senators do all day.) In an interview with Realty Times, QI Michael Anderson notes that you exchange "domestic properties for domestic properties and foreign properties for foreign properties." Sorry to tell you kids, but that means you can't exchange domestic properties for foreign ones. And you certainly can't avoid paying capital gains on the sale of an investment property if you're going to reinvest the money in your personal residence.
- ...use a QI you don't know. You can ask your CPA or real estate agent for recommendations -- and I would -- but you can't actually use your real estate agent or CPA. (The IRS publication 544 says that anyone who has "acted as your employee, attorney, accountant, investment banker or broker, or real estate agent or broker" for you in the two years prior to the transaction is disqualified, because they're technically your agent, so they're technically you and not a ninja/crossing guard.
- ...wait till the last minute to figure out what you're going to buy. You have 45 days -- this is called the "identification period" to figure out what substitute properties you might want. Exchangers typically identify three potential properties, figuring that they'll buy one -- that's one way to do it; but you could also identify a bunch as long as the value of the aggregate is not more than 200 percent of the value of what you're selling. Also note that when the IRS says "45" it means "45" strictly. Sunday counts; Christmas counts ... your government never sleeps! Similarly, you have 180 days, not 180 plus Christmas, to tie the entire transaction up.
- ...forget to put in the contract when you sell the first property that this is part of a 1031 exchange. I say this as an agent, who is now waiting for a long-delayed closing -- the other side will try hard to accommodate you and your time frame, but you have to let them know what it is.
- ...forget that the fair market value of a property isn't necessarily your basis. QI Gary Gorman notes on expert1031.com that if you did a 1031 three years ago for a $200,000 property, and a buyer gives you $175,000 for it today, you probably don't have a loss of $25,000. What the IRS wants to know is your basis for investment -- and if you had a basis of $125,000 in the original property, then on the sale you have a gain of $50,000.
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