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Navigating the ‘1031’ Tax Break

By Steve Matthews

Monday, December 3rd, 2018

The tax overhaul enacted last year made a lot of changes, but one provision cherished by real-estate investors survived: so-called 1031 exchanges.

It’s the name for a tax break that lets you defer capital-gains taxes on the sale of a property used for business or investment if you reinvest the proceeds in another business or investment property. Individual investors—even those who own a single rental-income property—can take advantage of it. The “1031” name refers to section 1031 of the U.S. tax code.

One typical way small investors use the provision is by selling one rental property and buying another. An example would be an investor who sells a rental property for what would have been a $100,000 gain. If that investor had simply taken the cash, he/she would have paid capital-gains tax. But instead, under the 1031 rules, the investor is able to defer paying those taxes by using the proceeds to buy another rental property.

The provision only applies to properties held for business or investment; a personal residence is not eligible for the tax break. You also must complete certain steps at set times. You have 45 days from the date of the sale of the old property to identify potential replacement properties. And you must acquire the new property no later than 180 days after the sale.

Many types of real estate qualify. An investor can exchange a single-family home held for investment in Pennsylvania for a farm in New Jersey or a small strip shopping center in Newark, as long as all those properties are used for business or investment purposes.

Many investors engage in successive 1031 exchanges, effectively swapping each of their properties into bigger and better ones. Ultimately, when the investor dies, the heirs who inherit the last property receive a “stepped-up basis,” which means that the property is valued at the market value at the time of death. If the heirs sell it then, there’s likely no gain—and hence, no capital-gains taxes due—on the sale.

Here are some things to consider if you’re interested in a 1031 exchange:

• Don’t forget about your vacation home. Interested in trading up to a larger or more-expensive vacation getaway? Consider converting your vacation home from personal use to business use by renting it out for at least 14 days a year for two successive years before the sale. After that, you can exchange it and defer capital-gains taxes as long as you continue to rent for a minimum of 14 days a year for two years after the sale. Consult with a tax adviser for details; there are limitations on your personal use.

• Make sure the deal makes business sense. Don’t do a 1031 exchange just to avoid taxes—the deal needs to make good business sense as well. If it doesn’t, consult with a tax attorney or financial planner to consider other tax-planning strategies.

• Beware of personal property. Personal property is excluded from like-kind exchanges. So, if you’re exchanging a property and it has appliances, you need to determine how much of the value is attributable to the property and how much for the appliances.