Here I'll explain some of the basic principles of the IRS sect 1031 tax DEFERRED (NOT tax FREE) exchange program. I had a few people call about the lot that had "1031 money they had to get rid of". If you are selling a property that you have a big cap gain on, you may want to consider doing a 1031 exchange. While there are some very strict unbendable rules and deadlines in the beginning, the back end of the exchange is, well, apparently sort of vague.
I'm not a lawyer nor tax attorney, so take this for what its worth. There is a lot of info online but I found a lot of it was ...not exactly correct. I got bad info from real estate agents that have been involved in 1031 transactions and lawyers, and homeowners who have done exchanges themselves! It seemed if you asked 10 people, you got 10 different answers. If you want an 11th wrong answer, call the IRS directly. The people who really know are the exchange intermediary companies, which are the companies that hold and disburse your money.
Some basic bullet points.
- First thing is, you have to use an exchange intermediary company. I used the one recommended by my lawyer since she had used them before and no one was sent to jail. This means the money from your sale goes directly to them, NOT to you. Its like an IRA rollover, the money never touches your hands. So, unless you take cash out up front (which you can but you will have to pay taxes on it), you walk out of closing with some paperwork with numbers on it and no money. Some company you have never dealt with (nor probably heard of) has all your money. Yea thats a little freaky.
- The intermediary company I used charged $1200 which included the first replacement property. There was a $200 charge for each additional property. I bought 4 properties with my proceeds so the total charge was $1800. I'm sure there are cheaper companies out there, but this wasnt something I was willing to "Dollar Tree". Doing the exchange allowed me to keep enough money working for ME (rather than the IRS) that I was able to buy another rental house (call it the 4th purchase). Net income after property taxes and insurance on that home pays that $1800 about every 2 months. If you look at it on a ROI basis, thats a 600% annual return on your money (the $1800) every year, not including appreciation in the underlying real estate. If you have a large cap gain, you are probably crazy not to do this.
- These are "like kind" investment exchanges, real estate for real estate, collector cars for collector cars, etc. As you can imagine, the definition of "like kind" could garner some confusion...or argument with the IRS. Basically, you cant sell your $1 million baseball card collection and buy real estate, but you CAN buy improved property (house or commercial) to replace unimproved property that you sold (land), or real property for real property. Its "like kind", not "exact kind" since no two pieces of real estate are exactly alike.
- If you are selling a house that was your primary residence, keep in mind that this is for "investment property" for "investment" property, NOT your primary residence. Besides unless you have a $250K gain if single, $500K if married, you arent paying any cap gains on the sale of your house anyway (as long as it was your primary residence 2 out of the last 5 years), so a 1031 is likely moot. If you are buying a home with this money (or some of this money)that will be your primary residence, you will need to take that money out of the exchange and pay taxes on it. In other words if you are buying a $200K house, you will need $266K to pay the taxes and have the $200K left for the house.
An interesting question for a tax accountant would be if you lived in the house 2 out of the last 5 but rented it out the last 2 years, could you treat it as both your primary, get the $250/500K deduction AND treat it as an investment property for a 1031 exchange for the profit over the $250/500K? Hmmm! While this would be an unlikely scenario in "America" because you would have to have a very large gain to make it worthwhile, I could certainly see this possibility on Nantucket.
This brings up another often heard rule with these that is incorrect: You have to spend ALL the money on the replacement property...this is FALSE...with a "but".
- You DO NOT have to spend ALL your proceeds from the sale on replacement properties. BUT, the money you do not spend is called "Boot" and IS taxable. So if you want to buy yourself a house, or treat yourself to a new car, you will need to take MORE than the cost of those things out of the exchange so you have the money to pay the taxes on that money (unless you have a bucket of cash hanging around, of course). So if you want that $50,000 Lexus, take out $66,666 so when you pay your 20% federal and 5% Mass tax (25% total), you have the $50K for the car plus the $16,666 (25% of $66,666) for The Man. You might as well take out the sales tax if you live in Mass ($4166 which includes the 25% tax. Yep, thats tax on tax! Isnt that just lovely?). If you live in SC the max sales tax on a car is $300 (YES its $3866 cheaper to buy your $50,000 Lexus in SC than in MA, isnt that just lovely too?).
- If this was your principle residence for 2 of the last 5 years, you dont pay any cap gains for the first $250,000 of profit if you are single, $500,000 if you are married. So if this is the case, chances are you are not going to have any tax liability anyway, so moot point. For me it was land that I was selling, so I didnt get this break even though I owned it for 17 years. Doing the 1031 in my case made the difference in buying an additional property that pays the cost of the exchange company's fee every 2 months, so it was a no brainer for me. If you are lucky and have property on Nantucket thats worth a bundle, your situation may make mine look like a lemonade stand.
- This is an investment exchange. That means you are selling "investment property" and buying replacement "investment property", so like a trade. It does NOT mean you have to buy anything from the buyer of your property. I sold my land in MA and bought property (4 actually) in SC from 4 completely different people.
- You will need to have language in your contracts (both buying and selling) that state this transaction is part of an IRS 1031 exchange and buyer or seller agrees to cooperate in. Sometimes it will state at the exchanger's expense (if there is any). Some people are worried it will complicate matters for them, or cost them something. It really doesnt.
- You have 45 DAYS (calendar days including weekends and holidays) from the sale of your property to identify (meaning fill out and sign a form) possible replacement property or properties. This is BY FAR the most important part of these exchanges. This 45 days goes FAST. If you dont identify ANY properties by this date, the exchange is over and the entire amount of the gain in your sale is Boot and is taxable. You should have done a lot of research on properties you are interested in before yours even closes so you can hit the ground running. I did 10 years worth LOL.
- You have 180 days (not 6 months! 180 calendar days!) to CLOSE on those properties. Since you are now a cash buyer, closing is usually not a problem (I had all my replacement properties closed in 70 days). The exchange company I dealt with wanted only 2 days notice for disbursements, so you could literally close in a few days. Dont do that though! Use that due diligence time (note: 10 BUSINESS days is better than just "10 days") everyone puts in contracts so you can get inspections and to allow for a title search, etc. If for some (ANY) reason you dont close on your identified properties within that 180 day time frame, that amount becomes Boot and is taxable. So, if you close on that $200,000 house on day 181, you might be liable for a $50,000 tax bill! For this reason, I would stay away from things that can drag on like foreclosures and especially short sales!
- You can identify up to 3 replacement properties of ANY VALUE. In other words if your property sold for $1M, you can identify 3 $1M properties, etc. OR:
- You can identify up to SIX replacement properties so long as the TOTAL value of those properties does not exceed TWICE the value of what you sold. This is known as the 200% rule. So if you sold that property for $1M, make sure the total value of your identified replacements doesnt add up to more than $2M if you identify 4, 5, or 6 properties. There is a form you fill out where you list your selections, and you can stipulate how many of those properties you intend to purchase. When I was getting close to the end of the 45 day period, I already had closed on 3 properties, with one more to go that was going to close after the 45 days were up, so I picked 2 more properties as a safety net in case something blew up with the last deal. Once that 45 days is up, you cannot go back and change anything on that list! I stipulated that I intended to buy only 4 of the 6 listed properties, so once I closed on the 4th property, the exchange ended and any leftover money came to me (as Boot and it is taxable, of course). Had I not stipulated that I was only buying 4 of the 6 properties I identified, I would have had to wait until the natural expiration of the exchange (180 days from the sale) to get my residual cash, which at this point was nearly 4 months away (actually its July 2, 2017, hasnt even come yet and all this seems like years ago already).
- There are ways you can identify more than 6 (95% rule) but it gets pretty complicated and probably applies to nearly no one so I wont get into it here.
- Cost Basis Pro ration. You will, of course, need to figure your cost basis for the property you are selling. This will be what you paid for it (or what whoever gave it to you paid for it), what you put into it for improvements, property taxes, etc. Once you have that, it gets transferred to the new replacement property (ies). That is now the cost basis for the new property. If you buy more than one replacement property, the cost basis gets assigned to the new properties according to their proportion of the proceeds that were used to buy them. In other words if the cost basis of your $1M sale was $100K, and you bought 3 properties costing $300K, $400k, $200K and say you took $100K out in cash, the cost basis would get doled out at $30K, $40K, $20K and $10K respectively. So your 100K cash-out would actually be figured on 90K because 10% of the cost basis gets assigned to it. You will notice you now have big cap gains in the new properties just like you did on the original property. You didnt avoid it, you deferred it. I initially hoped I could assign my cost basis anywhere I wanted, like the cash-out so I wouldnt have to pay taxes on it...(yes that would have put a near zero cost basis on the rental properties I bought), but thats not how it works (Bummer! It will have to be a used Lexus...actually I like old Mercedes, early 70's models like the 280SEL).
- Fixer Uppers. There is a provision for putting improvement costs of the new (replacement) properties in the exchange, BUT you cannot close until after they are finished (set up some trust with your lawyer? I dunno), and the 180 Day rule still applies. This almost NEVER works out and I would completely avoid it. If your replacement property needs repairs, use out-of-exchange money to do it rather (which makes it cost more in order to pay the tax on it) than risk a tax liability on the entire purchase price of the house. This will likely limit the "fixerupperness" of the properties you might buy. It caused me to avoid them completely.
- Can you EVER live in any of your replacement properties? The ambiguous answer I get is "They like to see at least a year...or two... of investment income before you claim it as a principal residence."
Hmmm. So I can, after a year....or two...move in and call it my primary residence? Stay there for 2 years, then sell it capturing the tax FREE (not deferred) $250K/$500K, which would wipe out any cap gains tax at all (in most properties anyway)? Its not spelled out, and like I said above it is vague, but apparently thats what some people are doing. So I guess the answer is yeaIguesssomaybesortofbutnotofficially.
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