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Donna Menser 916.801.2919
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A 1031 Exchange (also called a like-kind exchange or a Starker) is a swap of one business or investment asset for another. Although most swaps are taxable as sales, if you come within 1031, you'll either have no tax or limited tax due at the time of the exchange. The Menser Real Estate Group often assists their clients in selling and identifying a replacement property for a 1031 exchange.
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 many times or how frequently you can do a 1031. You can roll over the gain from one piece of investment real estate to another to another and another. Although you may have profit on each swap, you avoid tax until you actually sell for cash many years later. Then you'll hopefully pay only one tax, and that at a long-term capital gain rate (currently 15%).
Warning: Special rues apply when depreciable property is exchanged in a 1031. .It can trigger a gain known as "depreciation recapture" that is taxed as ordinary income. In general, if you swap one building for another building, you can avoid this recapture. But if you exchange improved land with a building for unimproved land without a building, the depreciation you've previously claimed on the building will be recaptured as ordinary income.
In 2004 Congress tightened that loophole. Yes, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Example: You stop using your beach house, rent it out for six months or a year and then exchange it for other real estate. If you actually get a tenant and conduct yourself in a businesslike way, you’ve probably converted the house to investment property, which should make your 1031 exchange OK. But if you merely hold it out for rent but never actually have tenants, it’s probably not. The facts will be key, as will the timing. The more time that elapses after you convert the property’s use the better. Although there is no absolute standard, anything less than six months of bona fide rental use is probably not enough. A year would be better.
If you want to use the property you swapped for 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 investment property for purposes of a 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange: (1) you must rent the dwelling unit to another person for a fair rental for 14 days or more; and (2) your own 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/investment property for another, you can’t immediately convert it 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 of time, 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 the 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 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.