THE COUNTY AND PARTICULARLY THE TOWN OF BRECKENRIDGE IS NO LONGER GIVING SHORT TERM RENTAL LICENSES BASED ON THE “NEED” FOR A 1031 EXCHANGE UNLESS A 1031 DOCUMENTATION CAN BE PROVIDED TO THEM BY THE IRS.
As these type of changes and requirements are happening in the county on a regular basis, make sure you are aware of these new and updated regulations when selling or purchasing a property here.
As always, current and future property owners in Summit County need to seek good tax and legal counsel when proceeding.
As real estate brokers, were are required to disclose in our contracts that a property is being transferred with a reference to a 1031 Exchange and are happy to put you in contact with the reputable intermediaries to assist in the completion of the types of transactions.
What you need to know:
The exchange is a swap of one investment property for another that allows capital gains taxes to be deferred. The term—which gets its name from Internal Revenue Code (IRC) Section 1031
What Is Section 1031?
Section 1031 is a provision of the IRS that allows a business or the owners of investment property to defer federal taxes on some exchanges of real estate.
The provision is used by investors who are selling one property and reinvesting the proceeds in one or more other properties. It is not available to buyers or sellers of personal homes for their own use.
Qualifying Section 1031 exchanges are called 1031 exchanges, like-kind exchanges.
Understanding Section 1031
The name Starker Loophole has been attached to the law since a 1979 court ruling concluded that an agreement to exchange property, within certain time limits, is essentially the same as a simultaneous transfer of property.
The loophole used to be much more generously defined. Prior to Dec. 31, 2017, like-kind property could be any of a broad range of real and tangible personal property held for business or investment purposes including franchises, art, equipment, stock in trade, securities, partnership interests, certificates of trust, and beneficial interests.
In effect, you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain That allows your investment to continue to grow tax deferred. There’s no limit on how frequently you can do a 1031. You can roll over the gain from one piece of investment real estate to another, and another, and another. Although you may have a profit on each swap, you avoid paying tax until you sell for cash many years later. Then, if it works out as planned, you’ll pay only one tax at a long-term capital gains rate (currently 15% or 20%, depending on income—and 0% for some lower-income taxpayers).
To qualify, most exchanges must merely be of like-kind—an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But there are traps for the unwary.
The 1031 provision is for investment and business property, although the rules can apply to a former primary residence under certain conditions. There are also ways that you can use 1031 for swapping vacation homes—more on that later—but this loophole is much narrower than it used to be.
To qualify for a 1031 exchange, both properties must be located in the United States.
Important Time Lines to Meet:
1. 45-Day Rule
The first relates to the designation of a replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can’t receive the cash, or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property that you want to acquire.
The IRS says you can designate three properties as long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.
2. 180-Day Rule
The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old property.
The two time periods run concurrently, which means that you start counting when the sale of your property closes. For example, if you designate a replacement property exactly 45 days later, you’ll have just 135 days left to close on it.
It’s also possible to buy the replacement property before selling the old one and still qualify for a 1031 exchange. In this case, the same 45- and 180-day time windows apply.
To qualify, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and then complete the transaction within 180 days after the replacement property was bought.
Internal Revenue Service. “Like-Kind Exchanges Under IRC Section 1031.” Accessed Nov. 17, 2021.
1031 Exchange Tax Implications: Cash and Debt
You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as boot—will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
One of the main ways that people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property that you relinquish, as well as any debt on the replacement property. If you don’t receive cash back but your liability goes down, then that also will be treated as income to you, just like cash.
Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property that you receive in exchange is only $900,000. In that case, you have a $100,000 gain that is also classified as the boot and will be taxed.
How can a 1031 be used for a Rental/Vacation Property here in Summit County
You might have heard tales of taxpayers who used the 1031 provision to swap one vacation home for another, perhaps even for a house where they want to retire, and Section 1031 delayed any recognition of gain. Later, they moved into the new property, made it their primary residence, and eventually planned to use the $500,000 capital gain exclusion. This allows you to sell your primary residence and, combined with your spouse, shield $500,000 in capital gain, as long as you’ve lived there for two years out of the past five.
In 2004, Congress tightened that loophole. However, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Example: You stop using your ski mountain house, rent it out for six months or a year, and then exchange it for another property. If you get a tenant and conduct yourself in a businesslike way, then you’ve probably converted the house to an investment property, which should make your 1031 exchange all right.
Per the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.
Moving Into a 1031 Swap Residence
If you want to use the property for which you swapped as your new second or even primary home, you can’t move in right away. In 2008, the IRS set forth a safe harbor rule, under which it said it would not challenge whether a replacement dwelling qualified as an investment property for purposes of Section 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange:
- You must rent the dwelling unit to another person for a fair rental for 14 days or more.
- Your personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
Moreover, after successfully swapping one vacation or investment property for another, you can’t immediately convert the new property to your primary home and take advantage of the $500,000 exclusion.
Before the law was changed in 2004, an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence.
Now, if you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date when the property was acquired in the 1031 like-kind exchange. In other words, you’ll have to wait a lot longer to use the primary residence capital gains tax break.
1031s for Estate Planning
One of the downsides of 1031 exchanges is that the tax deferral will eventually end and you’ll be hit with a big bill. However, there is a way around this.
Tax liabilities end with death, so if you die without selling the property obtained through a 1031 exchange, then your heirs won’t be expected to pay the tax that you postponed paying. They’ll inherit the property at its stepped-up market-rate value, too.
These rules mean that a 1031 exchange can be great for estate planning.
How to Report 1031 Exchanges to the IRS
You must notify the IRS of the 1031 exchange by compiling and submitting Form 8824 with your tax return in the year when the exchange occurred.
In the form, you’ll be asked to provide descriptions of the properties exchanged, the dates when they were identified and transferred, any relationship that you may have with the other parties with whom you exchanged properties, and the value of the like-kind properties. You’re also required to disclose the adjusted basis of the property given up and any liabilities that you assumed or got rid of.
It’s important to complete the form correctly and without error. If the IRS believes that you haven’t played by the rules, then you could be hit with a big tax bill and penalties.
Can You Do a 1031 Exchange on a Primary Residence?
Usually, a primary residence does not qualify for 1031 treatment because you live in that home and do not hold it for investment purposes. However, if you rented it out for a reasonable time period and refrained from living there, then the primary residence becomes an investment property, which might make it eligible.
Can You Do a 1031 Exchange on a Second Home?
1031 exchanges apply to real property held for investment purposes. Therefore, a regular vacation home won’t qualify for 1031 treatment unless it is rented out and generates an income.
How Do I Change Ownership of Replacement Property After a 1031 Exchange?
If that is your intention, then it would be wise not to act straightaway. It’s generally advisable to hold onto the replacement property for several years before changing ownership. If you get rid of it quickly, the Internal Revenue Service (IRS) may assume that you didn’t acquire it with the intention of holding it for investment purposes—the fundamental rule for 1031 exchanges.
Finding a financial advisor can be challenging, but the right professional can help you create a financial strategy that meets your investment and retirement goals. Also make sure you have an experienced, local real estate broker handling your real estate transactions and put you in touch with our local intermediaries here in Summit County!