Tag Archives: capital gain taxes

What Property Qualifies for a 1031 Exchange? (Part Three)

This is Part Three of our series on what property qualifies for a 1031 exchange.  You can also see Part One and Part Two.

In deciding whether a particular property has been held for productive use in a trade or business or for investment, the IRS looks at how you have characterized that property on your tax returns. If you have historically taken depreciation on or reported rental income on a property, there should not be any problem with that property qualifying for a Section 1031 exchange.

In addition, it is important to note that the IRS has ruled that the Section 1031 requirement that property be “held for productive use in a trade or business or for investment” excludes primary residences, vacation homes (when they are not held for investment), and second homes. When a personal residence is exchanged for other property, the Section 121 exclusion rule applies (providing that up to $250,000 of capital gain, or up to $500,000 for a married couple, is not taxable), not Section 1031.

The burden of establishing that a property is held for productive use in a trade or business or for investment (and not for a non-qualifying use such as inventory for resale) is on the exchanger, not the government.

The “for investment” requirement is somewhat trickier than the requirement that the property be “held for productive use in a trade or business,” since all property could conceivably be considered an investment.

Each property must be evaluated on a case-by-case basis. What the IRS looks at is the intent of the property owner and whether, on balance, the property is held for investment purposes or personal enjoyment.

If you want to do a Section 1031 exchange of property that you now use as your primary residence or as a second or vacation home, you must first turn it into qualifying property that is productively used in a trade or business or for investment. In other words, even property you have used as a primary residence, a second home, or primarily for personal enjoyment as a vacation home, may still qualify for an exchange under Section 1031 – if you re-characterize that property by using it for business purposes for a sufficient period of time.

The date the IRS uses to determine whether property has been held for a qualifying business use is the date of the transaction; any previous use is theoretically irrelevant. There is also no clear rule regarding how long a “holding period” is required in order to re characterize property and qualify for a Section 1031 exchange. Tax advisors recommend a period of one to two years (opinion is split on which time period is sufficient, but in no case less than 12 months) in the new use, and that you are able to report rental income and deduct depreciation and other business expenses regarding the property on your tax returns for that period of time.

It should also be noted that one can also exchange many types of non-real estate property that is held for investment or used in a business. For example, an airline can sell its airplanes as part of a like-kind exchange and avoid recapture of depreciation.

But the “like-kind” requirement is interpreted much more narrowly by the IRS for non-real property than for real property. While any real property held for trade or business use or for investment and located in the United States can be exchanged for any other real property held for trade or business use or for investment use and located in the United States, non-real estate properties exchanged under Section 1031 must be essentially the same type of asset.

Airplanes can be exchanged for airplanes, trucks for trucks, pizza ovens for pizza ovens, oil digging equipment for oil digging equipment; but airplanes cannot be exchanged for trucks, and oil digging equipment cannot be exchanged for pizza ovens. In addition, franchise rights and certain types of licenses can also be exchanged under Section 1031.

The replacement property, like the relinquished property, must meet certain requirements to be eligible for a Section 1031 exchange.

First, the replacement property, like the relinquished property, must be property, not securities or services, and it must be intended for “productive use in a trade or business or for investment.” 

Section 1031 applies only to “the exchange of property…for property.” For this reason, you cannot exchange property for securities or services. As with the relinquished property, this is a matter of the how the exchanger intends to use the property. The use of either property by the other party in the exchange is irrelevant.

Second, the replacement property must be of a “like-kind” to the relinquished property. What does “like-kind” property mean? In a typically obtuse ruling, the IRS has stated that:

“As used in IRC 1031(a), the words like-kind has reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.”

Got it? Okay, now let’s unpack the “like-kind” requirement in language that makes sense.

As used in Section 1031, “like-kind” property does not mean property that is exactly alike – or even alike at all in any normal sense. Instead, the IRS interprets the “like-kind” requirement very broadly – so broadly that if two or more properties are located in the United States and are held for productive use in a trade or business or for investment, they are considered “like-kind” property under Section 1031.

In other words, all real property located in the United States is considered “like-kind” to all other real property located in the United States.

Conversely, foreign property such as property located in Canada or Mexico) or in overseas U.S. possessions, such as Guam or Puerto Rico, is not considered “like-kind” to any property located in the United States.

But urban real estate in Los Angeles can be exchanged for a ranch in Utah, a ranch in Utah can be exchanged for a factory in Delaware, a factory in Delaware can be exchanged for a gas station in Las Vegas, and a gas station in Las Vegas can be exchanged for a conservation easement in Seattle. The quality or type of the real property does not matter so long as each real property is located in the United States. Under Section 1031, an apartment building in Chicago can be exchanged for an office building in Los Angeles, an office building in New York can be exchanged for a car wash in Nashville, a car wash in Seattle can be exchanged for a tenancy-in-common ownership in a resort in San Diego, and a tenancy-in-common ownership in a mall in Arizona can be exchanged fortimberland in Oregon, a farm in Wisconsin, a factory in Pennsylvania, or a gas station in Louisiana.

The fact that one property is improved and the other property is unimproved, or that one property is in a run-down part of a city while the other property is located in an upscale neighborhood is irrelevant.  Moreover, even partially completed property can, if properly identified, qualify as “like-kind” property with completed property. The “like-kind” requirement refers to the nature or character of property, not to its grade or quality. As long as a property is located in the United States and is “held for productive use in a trade or business or for investment,” it is “like-kind” to every other property located in the United States that is “held for productive use in a trade or business or for investment.”

See also “What Property Qualifies for a 1031 Exchange?” Part One and Part Two.

To contact Melissa J. Fox for 1031 exchange or other real estate or legal services, send an email to strategicfox@gmail.com

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Why Do a 1031 Exchange in a Down Real Estate Market?

Should you consider a 1031 exchange in a down real estate market?

In the booming real estate market of a few years ago, property owners saw their real estate assets increase dramatically in value.  As a result, if they sold their property they would have significant capital gains and therefore owe significant capital gains taxes that could be deferred or eliminated by a 1031 exchange.

Such dramatic increases in value are much less common in our current real estate market.  In fact, many properties have decreased in value, and would not lead to significant capital gains taxes if sold.

The question then is: if your property has not significantly appreciated in value, and you will not have a significant capital gain if the property is sold, is there still a reason to do a 1031 exchange?

The answer is yes.

Most people think of 1031 exchanges only in regard to avoiding capital gains taxes.  That’s only half the story.

In almost all real estate transactions, capital gains taxation has two components – taxes on actual gain and recapture of depreciation. The depreciation recapture provisions of Section 1250 (real property) and Section 1245 (personal property) apply to Section 1031 exchanges as well as sales. These provisions require depreciation to be recaptured at the higher ordinary income rate (instead of the long-term capital gain rate) when the property is sold or exchanged and a gain is recognized.

On the other hand, if you exchange property that is subject to recapture and no gain is recognized, the recapture potential of the relinquished property is not paid by you, but instead, carries over to the replacement property.

Moreover, this recapture potential can be deferred endlessly if you continue to transfer the property through Section 1031exchanges.

Thus, from a dollar perspective, avoiding the recapture of depreciation is just as important – and often more important – than avoiding taxes on actual capital gain since the monetary amount demanded by the government as recapture of depreciation is often larger than the taxes on actual capital gain.

In order to properly understand how recapture of depreciation works, you must first understand depreciation, and especially how the government looks at depreciation.

Simply stated, depreciation is loss of value. Over time all property except unimproved land depreciates, in the sense that over time all property except unimproved land undergoes wear and tear, becomes obsolete, and loses some of its physical integrity as foundations settle, damage is caused by long term exposure to air, water, and insects, and materials such as wood, metal, and concrete deteriorate.

The tax code properly recognizes this natural loss of value over time and allows property owners to deduct a prorated portion of this natural and inevitable loss of value each year from the owner’s basis in the property.

Deductions based on depreciation are taken according to schedules established by the IRS. For residential real estate and improvements, depreciation is taken over 27 years (known as the recovery period). For all other real property, including nonresidential investment property, depreciation is taken over a recovery period of 31 years.

While different kinds of assets are depreciated by different methods, all real properties, including buildings and permanent improvements, are currently depreciated using the straight-line depreciation method. Under the straight-line depreciation method, an identical proportional amount is deducted from your taxes as depreciation each year over the entire recovery period.

Crucially, because depreciation reduces your adjusted basis in a property, it has the effect of increasing the amount of profit – or, more precisely, the amount of capital gains that the IRS insists that you pay tax on when you sell the property.

The longer you’ve owned a particular property, the more depreciation has been taken and the lower your adjusted basis. Thus, the longer you own a particular property, the more depreciation will increase the amount of taxable capital gain, even without any cash profit due to appreciation.

For example, let’s say that you purchased a property 20 years ago for $400,000 and sell it today for exactly the same amount. You have absolutely no profit due to appreciation. But because of the depreciation allowable over the 20 years that you have owned the property, you will still have a taxable capital gain of approximately $300,000, even though you will have no cash profit whatsoever.

Even more significantly, even though you have no cash profit, you would still owe the government capital gains taxes of approximately $45,000!

Using a Section 1031 exchange allows you to legally avoid paying this tax, and instead, legally keep the money that you have deducted from your taxes as depreciation over the time that you’ve owned the property.

It is also important to note that the scheduled deductions for depreciation (and the resulting decrease in your property’s basis) are built into the tax code and are not at the discretion of the taxpayer. In other words, you cannot choose whether to depreciate your property and, hence, decrease your basis.

Even more significantly, you cannot claim an exemption from the recapture of depreciation because you did not, in fact, take the deductions due to depreciation that you were entitled to.

The government simply and absolutely assumes that you have taken all scheduled depreciation deductions, regardless of whether you have actually taken the depreciation deductions or not, and will insist that this allowable depreciation be “recaptured” when the property is sold.

So the answer to the question “Should I consider a 1031 exchange in a down real estate market?” depends not only on your actual capital gains, but also whether you want to avoid paying the government the amount of depreciation that the property has been entitled to during the time you have owned it.

In many cases, the answer will be yes.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

1031 Exchange Q and A: Can Developers Use 1031 Exchanges?

Here is another in our series of 1031 exchange questions and answers. 

This Q and A concerns “dealer’s property” and whether a developer can use a 1031 exchange.

Simon is the owner of “Ace Estates,” a real estate development business in Irvine, California.  He buys undeveloped land, hires architects and contractors, builds houses on the land, and then sells them to the public.

Felix has asked Simon whether he would be willing to do a Section 1031 exchange of one of Simon’s new houses for some land that Felix owns near Seattle, Washington.

Simon wants to expand his development projects, and he thinks that property values are still positive in the Seattle area.  He thinks Felix’s proposal is a great way to get a start in Seattle, and also legally avoid paying capital gains taxes on his profit from the house that Felix wants.

Can Simon exchange the house in Irvine for the land in Seattle under Section 1031?

Unfortunately, Simon cannot use any of the houses built and developed by Ace Estates for a Section 1031 exchange, because the IRS considers such properties to be inventory, intended primarily for sale, not business use or investment (known as “dealer’s property”).

Under Section 1031, inventory, stock in trade, or any other property that is held primarily for sale rather than business use or investment (“dealer’s property”) is disqualified from tax-free exchange.

Property is considered inventory when it is held for sale to customers in the ordinary course of business. For example, if you own a business that sells airplanes, then you cannot use one of those airplanes as qualified property in a Section 1031 exchange.

The dealer property exclusion rule also means that real property held for sale by dealers in real estate does not qualify for Section 1031 exchanges. Here, Simon is a dealer in real estate (he sells houses that he builds) and therefore can not use a 1031 exchange to transfer his inventory.

From 1031 Exchanges Made Simple, available at Amazon.com. 

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com