Thinking of moving to the Holy City or owning a vacation home at the beach?
Do you own commercial real estate and want to trade that investment property for another? Are you moving from another country or another state?
If so, here’s a way to Have it all without paying Uncle Sam a dime.
Any property owner who is considering selling or buying a second home should consider the substantial money saved with the 1031 Exchange. This uncomplicated legal provision allows an owner to avoid hefty capital gains taxes and increase buying power by identifying and acquiring a "like kind" property within a specific period.
If an owner nets $1 million for selling a house, and is subject to 20-30% capital gains taxes, the value of the sale comes out to only $700,000-$800,000, with Uncle Sam taking the lion’s share of the profits.
Following the rules of the 1031 Exchange, however, the owner won't pay one cent in capital gains, in this case adding a whopping $200,000-$300,000 to the next property purchase.
Here are the Basics:
A tax-deferred Section 1031 exchange is a great tool for real estate owners. It allows you to unload one property (the relinquished property) and acquire another one (the replacement property) without triggering a current income tax bill on the relinquished property’s appreciation (the difference between its fair market value and its tax basis).
The untaxed gain gets rolled over into the replacement property where it remains untaxed until you sell the replacement property in a taxable transaction.
But if you still own the property when you die, any taxable gain may be completely washed away thanks to another favorable rule that steps up the tax basis of a decedent’s property to its date-of-death value. So taxable gains can be postponed indefinitely, or even eliminated altogether if you die while still owning the property.
The IRS opened up a “safe-harbor” that allows tax-deferred Section 1031 exchange treatment for swaps of mixed-use vacation properties.
To be eligible for the safe-harbor, you must meet the guidelines explained below for both the relinquished property (the property you give up in the swap) and the replacement property (the property you receive).
When you meet these guidelines (along with all the other Section 1031 exchange rules), your swap will qualify for the safe harbor, which means it will automatically pass muster with the IRS.
Relinquished Property Guidelines:
For the relinquished property, you must pass both of the following tests.
First Test: You must have owned it for at least 24 months immediately before the exchange.
Second Test: Within each of the two 12-month periods during the 24 months immediately preceding the exchange: (1) you must have rented out the property at market rates for at least 14 days and (2) your personal use of the property cannot have exceeded the greater of 14 days or 10% of the days the property was rented out at market rates.
Replacement Property Guidelines:
For the replacement property, you must pass both of the following tests.
First Test: You must continue to own it for at least 24 months immediately after the exchange.
Second Test: Within each of the two 12-month periods during the 24 months immediately after the exchange: (1) you must rent out the property at market rates for at least 14 days and (2) your personal use of the property cannot exceed the greater of 14 days or 10% of
the days the property is rented out at market value.
Here’s an Example:
Say you have a mixed-use vacation home that’s worth $800,000. It has a tax basis of only $200,000 and no mortgage. If you sold it, you would have to report a $600,000 taxable gain ($800,000 - $200,000) on Form 1040. Yikes!
However, if you want to acquire another vacation home, you could arrange a Section 1031 exchange. Say you find another home worth $900,000 that you would love to own. So you swap your old vacation home (the relinquished property) for the new one (the replacement property) and throw in $100,000 cash to equalize the trade. As long as you meet the aforementioned usage guidelines for both properties, you can pull off a tax-deferred Section 1031 exchange and thereby avoid any current income tax hit. Congrats! Your tax basis in the replacement property is $400,000 ($800,000 - $400,000 gain rolled over from the relinquished property.
The Bottom Line
The ability to arrange IRS-approved Section 1031 swaps of appreciated vacation homes is a great tax-saving opportunity.
However, you cannot make a Section 1031 exchange of a vacation home that you’ve used strictly for personal purposes. That said, you can set yourself up for a future Section 1031 exchange by renting the property out for enough days over the next 24 months to meet the relinquished property safe-harbor guidelines.
Swapping commercial property, apartment buildings, any investment property, will allow you to qualify for a 1031 exchange; staying within all the parameters that the IRS stipulates, will ensure a smooth transition from one property to another.
Call or text Josephine today to find out how you can buy or sell your investment property and pay no taxes, legally! 843-793-4023