InvestmentFireside Tax Talks with Steven Clem: 1031 Exchanges

By Holly Roberson, Guest Contributor 

Navigating the world of tax consequences is a full time job and we already have a full time job doing everything else. That is why we are doing a series of tax blogs with Steven E. Clem, E.A. who makes tax planning and wealth creation his full time job. He and the team at The Clem Collaborative are experts. In fact, Steven has earned the highest designation the IRS can award a tax professional: Enrolled Agent.

In our first “Fireside Tax Talk “ (only a lawyer and a self-proclaimed “tax geek” would probably find that an exciting Wednesday evening and frankly there was no fire but it seemed more regal to say), I sat down with Steven to ask a few questions about 1031 Exchanges. It seems that lots of people talk about them, but don’t really understand the ins and outs. We can all read the 26 U.S. Code Section 1031 but it’s much easier to hear an expert explain them in real English.

Here’s what he had to say …

What is a 1031 Like Kind Exchange?

Under Section 1031 of the U.S. Tax Code, an investor is allowed to defer capital gains tax on the sale of investment real estate, provided they “exchange” it for like-kind property (i.e. other real estate) of equal or greater value. Consider this example: An Investor purchased a rental house 20+years ago for $150K that has appreciated in value to $350K. After depreciation, the Adjusted Basis has been reduced to $60K. If the Investor simply sells the property, he/she could be required to pay Federal Taxes of as much as $80K or more. But, utilizing a 1031 Exchange, and rolling the proceeds into other investment real estate (residential or student rental, commercial rental, raw land, etc.), they can completely side-step the tax.

How do I “do” a 1031 Exchange? Is it just a check box on my taxes?

One of the biggest errors people make is in thinking that a 1031 Exchange is about intent. In reality, it is about specific action. To properly execute a 1031 Exchange, you must enlist a Qualified Intermediary. Title to the property being relinquished is transferred to the QI prior to the sale, who sells the property and holds the proceeds in Trust for the transferor. The QI then uses those proceeds to purchase the replacement property(ies) previously identified, and transfers title back to the transferor. In order for the Exchange to be valid, the owner cannot, at any time, have what the IRS refers to as “constructive receipt” of the funds. Each year, I have at least one new client come in and say “I sold a property and bought a property and I want to do one of those 1031 Exchange thingies.” That is when I have to break the bad news that 1031’s cannot be implemented retroactively and that the sale of their property will be a fully taxable event. (This is when the client usually avails themselves of our offer of a complimentary glass of wine. Sometimes a nip of Pinot makes the tax news go down a bit easier!)

I know I only have 180 days to close on an exchange property. Are there any other timelines I need to know about?

There are two important numbers to keep in mind with a 1031 Exchange: 45 and 180.
45 Days. From the time of the sale of the original property, you have 45 days to identify the replacement property and inform the QI. Understanding that sometimes deals fall through, the IRS allows you to identify up to 3 possible replacement properties, OR you can designate multiple properties as long as their aggregate value does not exceed 200% of the property being relinquished.

180 Days. From the time of the sale of the original property, you have 180 days to close on the purchase of the replacement property(ies). In some articles you will see reference to “six months.” It’s important to note that 180 days is slightly LESS than 6 months (which is typically 182 or 183 days), so be sure to count accordingly!

What happens if I identify a property and the closing does not go through? Can I start my timeline over?

Unfortunately, the IRS has a firm “No Takebacksies” rule! Fortunately, as outlined above, you can identify multiple properties as potential replacements. Also, your Luxury Simplified agent is well-versed in 1031 Exchanges, and can work with you to identify properties that have a high probability of closing on time.

Are professional fees (attorney, cpa, realtor) and other expenses related to the transaction allowed as part of the exchange expense?

Yes. (That was easy!)

What should I expect to pay in CPA and attorney fees?

The legal fees will be a factor of the complexity of the closing(s), but they generally aren’t materially more with a 1031 Exchange than they would be with a conventional sale/purchase. The cost of a Qualified Intermediary will typically vary based upon how many replacement properties are involved, but $750-$2000 is a reasonable range for those fees. Your Tax Professional will have to do some additional work to accurately report the Exchange as a component of your annual tax filings, so plan for that bill to run 20-30% higher than normal.

Can I buy an investment property and use my 1031 proceeds to fix it up?

Yes, as long as the improvements are completed and paid for within the 180 day time frame.

Can I convert the investment property into a personal residence later?

The assumption in a 1031 Exchange is that you are trading investment property for investment property. However, no one can fully predict the future, so if – at some point in the future – one’s needs change and the decision is made to convert an Investment Property into a Personal Use Property, that action does not in-and-of-itself invalidate the Exchange. As one would expect, much depends on the particular circumstances.

Is a vacation home ok to convert?

If a property is used solely for personal purposes, it does not qualify for a 1031 Exchange. If, however, the property is used both for personal and rental purposes, then it can qualify for a 1031 Exchange, provided certain provisions are met. Specifically, in each of the two years prior to the Exchange, the relinquished property must have been rented at Fair Market Value for at least 14 days, and the personal use portion cannot exceed the greater of 14 days or 10% of the time rented. Once the Exchange is completed, the replacement property must meet the same standard for each of the next two years.

Can I convert one property into 2 different rental properties including funds to fix it up?

Yes. You can actually Exchange one property for as many other properties as you wish, as long as the collective value of the new properties (including the cost of improvements) is equal to or greater than the property being relinquished.

If I sell an investment property for $1,000,000 and pay my mortgage of $250,000, I have $750,000. Do I buy a property for $750,000 or for $1,000,000?

To fully circumnavigate taxation, the newly acquired property(ies) must have a purchase price equal to or greater than the selling price of the relinquished property. Using the example above, the new property(ies) would need to have a purchase price of $1M or more. It is important to understand, however, that 1031 Exchanges are not “All or Nothing.” In the above example, the seller could choose to buy a replacement property for less than $1M. In that case, a pro-rata portion of the sale would be ascribed to the 1031 Exchange, and the remainder would be treated as a taxable sale.

Can I buy my parents’ home with my exchange AND use their gift tax exclusion to maximize my buying power, then rent it back to them?

Unfortunately, no. In a 1031 Exchange, a property can only be purchased from a Related Party (Spouse, Sibling, Ancestor, Lineal Descendent) if they also are doing a 1031 Exchange.

How does the 1031 Exchange apply to investment property I inherited and am now selling?

When one inherits a property, they benefit from a tax rule called “Stepped-up Basis.” That means that your Basis in the property is the value of the property at the time it passed to you – provided that number is equal to or greater than the adjusted basis of the person you inherited it from. So, for example, if your relative purchased a property for $250K, it was worth $500K when you inherited it, and then you sold it a couple of years later for $650K, your Adjusted Basis would be $500K, plus any improvements made and minus any depreciation taken during the time of your ownership.

When should I use something other than a 1031 Exchange to maximize my tax savings?

The 1031 Exchange is designed for individuals who wish to trade investment real estate for other investment real estate. If the property being relinquished is not currently being used for investment, and/or if you wish to invest in opportunities other than real estate, there are other avenues and vehicles available to allow for tax deferral.

NOTE:  The Clem Collaborative is available to be a Qualified Intermediary and walk you through your 1031 Exchange. And, as a Broker Associate with Luxury Simplified in Charleston, SC I’m more than pleased to help you identify a property within your time frame. 

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