Effective this year, the federal Tax Cuts and Jobs Act wiped out the 1031 exchange tax deferment benefit for personal property, such as primary residences, vacation homes, artwork and collectibles. That change might have caused confusion about how exchanges of real property, like office buildings, warehouses and self-storage facilities, would be treated by the IRS.
To the relief of high-net-worth (HNW) investors and family offices, Congress retained the 1031 benefit for real property. However, this doesn’t give HNW investors and family offices a license to indiscriminately swap properties.
Given that the Tax Cuts and Jobs Acts put a spotlight on 1031 exchanges, it’s a good time to review their tax implications, particularly as HNW investors and family offices explore tax planning ahead of the 2019 tax year.
As explained by the IRS, Section 1031 of the Internal Revenue Code lets an investor postpone paying federal taxes on capital gains from the sale of a real property if the proceeds are reinvested in a similar property through a “like-kind exchange,” or swap. The IRS emphasizes that the gains are tax-deferred, not tax-free.
What’s defined as like-kind property?
“Both properties must be similar enough to qualify as ‘like-kind’,” the IRS says. “Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.”
CPA Tom Wheelwright, CEO of wealth strategy firm WealthAbility and author of Tax-Free Wealth, recommends carefully studying the tax consequences—in consultation with tax and wealth advisers—before entering into a 1031 exchange. Experts also stress the importance of tapping an experienced “qualified intermediary,” also known as a 1031 accommodator or facilitator, to handle the exchange.
“Many taxpayers automatically assume that a like-kind exchange is the best tax planning tool available when it comes to selling property. This is not always the case,” says Wheelwright, who prefers tax avoidance strategies over tax deferment strategies.
For his part, tax attorney Steve Moskowitz, founder of law firm Moskowitz LLP, says anyone who’s considering the sale of real property, like an office building valued at $4 million, and the subsequent purchase of another piece of real property, like an office building valued at $5 million, should consider a 1031 exchange. This way, payment of capital gains taxes on the $1 million difference can be deferred, he says.
These exchanges, which date back to 1921, “present a powerful wealth-preserving and wealth-building opportunity for individual and corporate investors across the income spectrum. As such, it’s a good idea to include Section 1031 as part of any discussion around the disposition of any property that qualifies for like-kind exchange treatment,” says Steve Chacon, vice president of Accruit, a provider of technology enabling like-kind exchanges and other financial transactions.
While the benefits of a 1031 exchange are pretty easy to grasp, the rules are not. Those rules include identifying within 45 calendar days, in writing, your prospective like-kind replacement properties, and typically completing the entire 1031 process within 180 days, according to wealth adviser Samuel Moore, of Endowment Wealth Management Inc.
“Some taxpayers shy away from doing a like-kind exchange because it seems too complicated to fit with the goals they have for their property, even if the like-kind exchange can reduce their taxes,” Wheelwright says.
In lieu of lining up a replacement property within 45 days, an investor can execute a 1031 exchange through what’s known as a Delaware statutory trust, notes Moskowitz. This arrangement offers the same tax advantages as a regular 1031 exchange.
However, according to real estate investment platform RealtyMogul.com, the Delaware statutory trust does come with drawbacks, such as its status as a “truly passive investment,” its long-term hold periods (usually five to 10 years) and its potentially lower returns (often 6 percent to 7 percent a year).
If an investor does qualify for a 1031 exchange, failure to follow the rules can trigger “significant tax penalties,” according to Michael Sury, a finance lecturer at the University of Texas. Those include being held liable for paying the taxes that were supposed to be deferred, along with interest and fines. Serious 1031 violations, such as fraudulent backdating of paperwork, can lead to even steeper costs.
To avoid 1031 trouble with the IRS, Moore recommends avoiding the following scenarios:
- “Trading down.” This happens when you swap for a replacement property whose tax basis is lower than the property you already owned. In this instance, you’ll receive a “boot,” or financial benefit, that’s subject to taxation.
- Buying a “fixer-upper” and selling it as soon as it’s improved, as this property may be considered “stock in trade,” which would mean it wouldn’t qualify for a 1031 exchange.
- Being labeled a “dealer” because you exchange property too quickly after it’s acquired or trade several properties in the course of a year. If you fall into that category, your deals may be deemed “stock in trade” and become ineligible for 1031 exchanges.
The federal law does not dictate how long a 1031 investor must hold a property, Moskowitz notes, so it’s open to interpretation whether someone is swapping an asset too soon. A good rule of thumb, though, is to hang onto a property for at least two years, he says.
Experts say that if you stick to the myriad rules, a 1031 exchange can be a valuable investment tool. For example, the heirs of a HNW investor who’s been involved in qualified property swaps can reap substantial tax breaks, Moore says.
“If you continuously trade up properties and are still holding the properties when you pass away, your heirs receive a step-up in cost basis equal to the fair market value on the date of your death and the capital gains disappear,” he notes. “For high-net-worth individuals, this is a huge benefit due to their higher tax brackets.”
