Know Your Intent to Qualify for 1031 Exchange Tax Deferral (Updated for Tax Reform) by John G. Ebenger, CPA
Posted on April 02, 2018
Despite governmental efforts to repeal or limit taxpayer use of 1031 exchanges, a robust real estate market is continuing to drive demand for this powerful tax-planning tool. Under Section 1031 of the Internal Revenue Code, individuals may defer taxes on the sale of certain commercial real estate property when they reinvest the profits into new, similar property of equal or greater value. Essentially, money that taxpayers would have paid to cover taxes on the gain from a sale of one asset are instead reinvested in a similar asset, or assets, and treated by the IRS as a reinvestment of capital that is not subject to taxation. As a result, taxpayers may sell a long-held, low-tax-basis investment property that has appreciated in value without incurring significant federal and state income taxes, and they may change the form of the “like-kind” asset to allow their original investment dollars to continue to grow tax-free.
Yet, taking advantage of 1031 exchanges requires careful planning and understanding of a complex set of rules.
Definition of Like-Kind Property
To qualify for 1031 treatment, both the real estate sold and the real estate acquired must be “held for either productive use in a trade or business or for investment.” Because the law requires the properties for exchange to be of similar nature but not of the same quality, investors, developers or builders may swap a residential condo building for an office building or a retail complex for unimproved land. They may also exchange investment property for real estate used in their business or trade.
The Importance of Intent
To determine whether a transaction qualifies for 1031 treatment, the IRS looks at the property holder’s intent to use the real estate in a trade or business or for investment purposes by considering the following factors:
Frequency of Taxpayer’s Real Estate Transactions
The tax code allows taxpayers to engage in multiple 1031 exchanges in a year. However, the more property sales a taxpayer has, the more likely the IRS will consider he or she to be real estate “dealers” who must hold assets for sale. In most cases, this restriction will not meet the qualified-use test required for 1031 treatment.
Taxpayer’s Development Activity
A property may be disqualified from 1031 treatment when the taxpayer makes efforts to improve the asset through the addition of utility services, roads or other activities that can influence the gain on the sale of the property.
Taxpayer’s Efforts to Sell the Property
The IRS looks at the amount of time, effort and involvement a taxpayer expends to control the sale of property to determine the applicability of a 1031 exchange.
Length of Time Taxpayer Holds the Property
While there are no specific rules detailing how long a taxpayer must hold real estate for investment or business purposes to qualify for a 1031 exchange, the IRS generally accepts a period of two years. “Flippers” and other investors who purchase a property immediately prior to a 1031 sale or who sell a property soon after a 1031 transaction can be disqualified from claiming the benefit of tax deferral.
Purpose for which Taxpayer Holds the Property
The IRS considers the purpose for which the property is held at the time of sale to determine application of 1031 exchange tax benefits. The purpose for which the property was originally acquired may have no influence on the decision. Therefore, a developer may purchase raw land with the intent to build single-family homes and then, later build rental units or sell portions of the land. Similarly, a homeowner who purchases a primary residence may later decide to rent out the home for investment purposes and subsequently sell the property as part of a 1031 exchange.
The Tax Cuts and Jobs Act that overhauls the U.S. Tax Code beginning in 2018 preserves the use of 1031 exchanges to help investors extend the value of their real estate holdings. Yet, the tax code remains a complicated maze of provisions for which individuals should meet with tax professionals to assess relevant planning opportunities and take advantage of their ability to reinvest profits rather than paying capital gains tax.
About the Author: John G. Ebenger, CPA, is a director in the Real Estate Tax Services practice of Berkowitz Pollack Brant, where he works closely with developers, landholders, investment funds and other real estate professionals as well as high-net-worth entrepreneurs with complex holdings. He can be reached in the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at email@example.com.