Ep. 13: The Power of 1031 Exchanges: Saving Taxes and Growing Wealth
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Two of the best options for realizing a substantial gain and eliminating capital gains tax on the sale of an investment property are through the sale of your personal residence or an installment sale.
A third option to help you save on taxes and grow your wealth is to take advantage of 1031 exchanges, or rollovers.
Listen in as Attorney Ted Gudorf breaks down the seven essential must-knows around like-kind exchanges set forth in Section 1031 of the Internal Revenue Code.
- Personal residence (0:48)
- Installment sale (2:12)
- Eliminating capital gains tax using a 1031 rollover (3:55)
- The property must be like-kind (04:51)
- The 45-day rule (06:31)
- The 180-day purchase requirement (08:01)
- Use a qualified intermediary (08:48)
- The title must be mirrored in both transactions (10:05)
- Reinvest an equal or greater amount than the gain achieved in the original sale (11:32)
- Reverse exchanges (12:51)
- The long-term benefits of a 1031 rollover (14:04)
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Transcript: Prefer to Read — Click to Open
Hi, everyone! This is episode 13, 1031 exchanges, or better yet 1031 rollovers. You know, one of my favorite things to do is to teach my clients how to save taxes. Today’s session is going to focus in on the sale of investment real estate. Before I get into that, let us talk about the sale of a personal residence. Most of you know that Section 131 of the Internal Revenue Code allows us to sell our personal residence, obtain a significant gain on the sale, and that gain is exempted by virtue of the personal residence exclusion or exemption. Now there are some rules, primary rule is that it has to be used and owned as our primary residence. Number two, it had to be used and owned by us for two out of the last five years, and those rules are really left up to the taxpayer to be able to establish. But if we follow the rules, we can exempt, if we are a single person, up to $250,000 worth of gain on the sale of our personal residence or if we are a married couple, we can exempt up to $500,000 as long as we file a joint return. So, the sale of our personal residence is a very tax favored under the Internal Revenue Code.
Now another way to achieve tax savings on the sale of investment property is to do what is called an installment sale. Now when we do an installment sale, we take the sales proceeds, and instead of getting a lump sum payment, we agreed to take it over a period of years. The purpose of taking it over a period of years may be to put the gain and our other income in a 0% tax bracket where the capital gains tax is completely wiped out. That can be accomplished for a single person or a married couple, if the total taxable income, plus the gain, do not exceed a very nominal amount of money, less than $50,000 for a single person and less than $90,000 for a married couple. What is critically important in most installment sales of significant investment property is that we keep the gain that we are going to realize in any given year under the threshold so that we pay that 15% tax rather than a 20% tax, and again, if we are a single person, there is one threshold and if we are a married person, it is a higher threshold. We certainly do not want to have to pay the 20% tax if we can avoid it at all. Well, if we are not talking about a personal residence, and we are not going to do an installment sale, yet, we are going to realize substantial gain on the sale of investment property. What can we do to eliminate any capital gains taxes? Well, under the current tax code, we are allowed to do a 1031 rollover, oftentimes called the like-kind exchange. I think rollover is a better description because, in fact, that is really what we are doing with the gain that we are realizing off of the sale of the original property. We are going to roll it into a new property.
What I want to talk briefly about today is I want to bring some clarity to the seven essentials that surround a like-kind exchange set forth in Section 1031 of the Internal Revenue Code. The first essential is that the property must be like kind, that is that the property that we are going to purchase must be like kind to the one that we are selling. This is probably the most misunderstood aspect of it. It does not mean that if you have a rental property, you cannot exchange it into a vacant lot or it does not mean that you cannot roll it into a commercial property. That is really not what we are talking about. We are really talking about investment property or property that is used in a trade or business. It must be held for investment purposes. Why do I say investment purposes? Well, that is opposed to say something like flipping property. Flip property does not qualify, because it is being held for sale rather than for investment. Therefore, flipping property will not allow you to defer any gain through the 1031 process. But you can take, as I mentioned, a lot and sell it and roll it into a condo. It is important to understand that while you can sell property to a related party, you cannot be purchasing it from a related party as well. But that is the like kind issue, and it focuses more on the use of the property, is it being used for investment purposes.
Now the second essential element that we have got to understand is this 45-day rule. The 45-day rule says that 45 days after we close on the original property, and it starts the day after the closing, and we literally count 45 days, it is calendar days, and we are required to identify properties, and we are allowed to identify up to three properties of unlimited value, we do have to identify them by address or legal description, and we have to provide that address or legal description to a person that we call a Qualified Intermediary, that must be an independent person. If the 45th day falls on a holiday or a Sunday, it does not matter. The rule is strict, it must be 45 days. Now if for some reason, we are going to identify more than three properties, the total value of those properties cannot exceed 200% of the sales price that we achieved when we sold the original property. So, the safest route is to identify three properties because when we only identify three, they can be of unlimited value.
Now the next requirement, the third essential is the 180-day purchase requirement. What it simply means is that within 180 days of closing on the original property, we have to close on the new property. In other words, the 45-day and the 180-day period run consecutively, they run at the same time. It is a pretty simple requirement. We are just counting calendar days, and it is a hard and fast rule. If we do not meet it, then the transaction will be disallowed as a like kind rollover. The fourth essential element is that we make sure that we use a Qualified Intermediary. Most title companies will have somebody designated as their Qualified Intermediary. There is no license that they have to acquire to become one. They are not designated by the Internal Revenue Service. On the other hand, it does have to be somebody who has a separate account, so that the sales proceeds of the initial sale get deposited into that account. In other words, you as the owner of the property, you as the seller of the original property are not allowed to touch the funds anytime after closing. They have to be held by somebody else in a separate account. That is critically important. Furthermore, the Qualified Intermediary has to fill out the paperwork that gets submitted to the IRS with respect to the 1031 rollover, just remember, if they fill out the paperwork incorrectly, the IRS is going to disallow the transaction as a proper 1031 rollover. So, pick wisely, make sure you have somebody who is competent, who has done this before, and knows what they are doing.
Okay, step five, title must be mirrored in both transactions. Well, what does that mean? What it really means is that if your property that you own that you are going to sell is in your name alone, the gain that you realize to purchase the new property within the 180-day window must also be titled in your name alone. Now, if you for some reason, say you are married, and want the new property to be in a spouse’s name, just know that before you sell the original property, you simply need to quit claim an interest in the property to them, and then they can be added on the new property. Also, if you have a partnership, the way to go about it is to understand that this 1031 rollover works with respect to the real estate interest, not the partnership interest. So, if it is held in the name of a partnership, we are going to want to transfer the property out to the individual partners, who then will sell that property in their name, and then do the 1031 rollover in their name, and acquire a tenant in common interest in the new property in their individual name.
The sixth essential element that we want to talk a little bit about is to make sure that we reinvest an equal or greater amount than the gain that we achieved in the original sale. If we want to defer 100% of the gain. Obviously, there is no requirement that we defer 100% of the gain, but that is most often what my clients want to do, and so they just have to understand that the amount that they are reinvesting has to be equal or greater than the amount of the gain. Now, having said that, the IRS does allow us when we are selling the property, and realizing or calculating what the gain is, we can reduce the sales price by the sales commission, or reduce our gain by the sales commission, as well as the closing costs, and likewise, when we purchase property, we are allowed to add the commission to the purchase price, and that helps us out a little bit, but it is important that we want to defer 100% that we make sure that we reinvest in equal or greater amount than the gain we realized in the first purchase.
Let us talk briefly about the seventh essential. Now the seventh essential that I want to talk about deals with reverse exchanges. A reverse exchange is simply when somebody says to me, we want to buy this particular piece of property prior to selling our current property and still do a 1031 rollover. Well, the IRS a few years ago, decided it was going to sanction this kind of transaction, and they simply call it a reverse 1031 rollover. What is reverse? Well, you are buying the property first, and then selling the current property. Second, the primary requirement is that the sale of the original or the sale of your property that you currently own, must occur within 180 days of the closing date of the purchase of the new property. So, it is possible to buy a new property first, do the reverse exchange, and again continue to defer the capital gains tax. Now ultimately, at the end of the day, what is the primary benefit or why are we really trying to achieve a 1031 rollover? Well, it is for this purpose. If we have investment property, and maybe down the road, we want to convert that investment property to our residence, as long as we own and use the property for two out of the preceding five years, we can utilize the personal residence exemption that I started this podcast with.
So, give that some thought, maybe we are going to simply use this strategy to convert it to our personal residence, and the entire capital gains tax will go away. Or think about this, there is no limit on the number of 1031 rollovers that we are allowed to do. It is important to understand that the capital gains tax goes away at death, and our children can receive a step-up in tax basis at our death. Therefore, we can do successive 1031 exchanges, as long as we follow the rules, and that is ultimately our goal. Our goal is to follow the rules to make sure we can avoid the payment of the capital gains tax, as we purchase, sell and repurchase additional investment real estate. Well, I hope you found this podcast to be of interest. My hope is that it will provide some clarity and some confidence that will allow you to proceed to doing a 1031 rollover. Thanks for being with me today. Have a great weekend.
Ted is an excellent attorney, He is very successful because of his knowledge and because he focuses on his clients needs. I am very impressed with the Planning he has accomplished for families with large farm holdings. He is the one I would call for… Read More
– Jim Swain, Owner, Swain Law Firm