One of the most popular uses for a 1031 exchange is in the sale of real estate. 1031 real estate exchanges are popular and easy because the like-kind requirements are very broad in the world of real estate.
Like-Kind Real Estate
Nearly all real property within the USA is considered to be like-kind. The types of real property that may be exchanged include property held in fee, ground leases (with remaining terms of 30 years or more), undivided interests in real property held as tenants in common (TICs) and interest in “DSTs” or Delaware Statutory Trusts. Here is a partial list of some of the kinds of properties that qualify for 1031:
- Apartment Buildings
- Shopping Centers
- Airport Hangers
- Condos and Town Homes
- Raw Land
- Single Family-Rentals
- Industrial Property
Another reason people often structure the sale of real property as 1031 exchanges is because improvements (such as buildings) have been depreciated down over time, subjecting the sale to a maximum of 25% depreciation recapture rates (C corporations can be as high as 35%) on the portion of the gain that is attributed to the depreciation.
Depreciate your Investment Property
As a real estate investor, you can depreciate your real estate business and investment property. The maximum 20% capital gain rate is generally known as the long-term capital gains rate and is the maximum rate that applies to real estate that you have held for at least 366 days (more than one year).
There is also the Net Investment Income Tax (“NITI”) which is imposed by IRC Section 1411 and applies an extra rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts (2015 amounts: Married filing jointly = $250,000; Married filing separately = $125,000; Single = $200,000).
The long-term capital gain tax is typically a lot less than what you pay on your regular income. If your holding period has been for less than one year, consider deferring the gain on the sale through a 1031 exchange so that you can meet the greater-than-one-year period before cashing out on a later sale.
Holding Period for Determining Long-Term Capital Gains
If you receive a new business or investment property in exchange for old like-kind business or investment property as part of a tax-deferred 1031 exchange, your holding period begins on the day after the date the original (or old) property was acquired. This is because your basis in the new property is augmented by the deferred gains from your old property.
Remember, only real estate that you intend to use for Investment or for use in a trade or business qualifies for 1031 tax deferred treatment. The two main areas to be careful of are:
1. Personal Use: If you use real property for personal use such as your personal residence or vacation home, it may not qualify because it is not used for a qualified purpose (investment or business).
2. Dealer Property held Primarily for Sale: If you hold property as inventory or as your stock in trade it may not qualify for 1031. Ask yourself how frequently you sell residential lots or convert buildings to condominiums and sell the units, as part of your business. If you are doing enough of this type of activity, you may be a dealer and the real estate may be considered to be inventory. Flippers and rehabbers beware.
- 1031 Hotline: If you have questions about 1031 real estate exchanges, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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