If you're a savvy investor, you probably know that you must generally report as income any mutual fund distributions whether you reinvest them or exchange shares in one fund for shares of another. In other words, you must report and pay any capital gains tax owed.
But if real estate's your game, did you know that it's possible to defer capital gains by taking advantage of a tax break that allows you to swap investment property on a tax-deferred basis?
Named after Section 1031 of the tax code, a like-kind exchange generally applies to real estate and was designed for people who wanted to exchange properties of equal value. 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, nobody pays capital gains tax even if both properties may have appreciated since they were originally purchased.
Section 1031 transactions don't have to involve identical types of investment properties, they just have to be of "like-kind." In other words, personal properties of a like class are like-kind properties; however, livestock of different sexes is not considered like-kind properties. Furthermore, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties. For example, 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.
There's also no limit as to how many times you can use a Section 1031 exchange. It's entirely 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, but not forgiven, in a like-kind exchange, and you must calculate and keep track of your basis in the new property you acquired in the exchange.
Section 1031 is not for personal use. For example, you can't use it for stocks, bonds, and other securities, or personal property (with limited exceptions such as artwork).
Advance planning required
A Section 1031 transaction takes advance planning. You must identify your replacement property within 45 days of selling your estate. Then you must close on that within 180 days. There is no grace period. If your closing gets delayed by a storm or by other unforeseen circumstances, and you cannot close in time, you're back to a taxable sale.
Find an escrow agent that specializes in these types of transactions and contact your accountant to set up the IRS form ahead of time. Some people just sell their property, take cash and put it in their bank account. They figure that all they have to do is find a new property within 45 days and close within 180 days. But that's not the case. As soon as "sellers" have cash in their hands, or the paperwork isn't done right, they've lost their opportunity to use this provision of the code.
Personal residences and vacation homes
Section 1031 doesn't apply to personal residences, but the IRS lets you sell your principal residence tax-free as long as the gain is under $250,000 for individuals ($500,000 if you're married).
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 under the Section 1031 exchange.
However, if you want to use your new property as a vacation home, there's a catch. You'll need to comply with a 2008 IRS safe harbor rule that states in each of the 12-month periods following the 1031 exchange you must rent the dwelling to someone for 14 days (or more) consecutively. In addition, you cannot use the dwelling 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 for 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.
While they may seem straightforward, like-kind exchanges can be complicated. There are all kinds of restrictions and pitfalls that you need to be careful of. If you're considering a Section 1031 exchange or have any questions, please call.
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For the past 16 years Todd Hickman has co-hosted a weekly financial radio show on NewsTalk 560AM KLVI, airing each Sunday at 11AM. You can reach Todd during the week at 409-840-6900 or by visiting his company’s website at http://savemyretirement.com.