Section 1031 Exchange of Real Property Rules Explained
In the Tax Cuts and Jobs Act (TCJA), Section 1031 was amended to apply only to exchanges of real property, leaving taxpayers questioning what qualifies as “real property” under these new rules. The Internal Revenue Service (IRS) and Treasury Department addressed these questions as well as clarified other areas of this tax rule in its final regulations released in June 2020. Below is an overview of the final regulations and key considerations property owners should keep in mind related to the exchange rules.
Real business or investment property, including land, and generally anything permanently built on or attached to it. The following qualifying factors were also outlined under the final regulations:
- Real property also includes property characterized as such under applicable state or local law where it is located and can include intangible property such as leaseholds or easements.
- Tangible property permanently attached to the real property and ordinarily would remain attached for an indefinite period would qualify for 1031 treatment since the “purpose or use test” was removed.
- Generally, if personal property is included in the transaction it will not qualify for 1031 treatment. If the personal property is “incidental”, it will not remove the 1031 treatment, however, it would be subject to the gain treatment. Under the final rules, incidental personal property is both:
- Typically transferred with real property in a standard transaction.
- The aggregate fair market value does not exceed 15% of the aggregate fair market value of the replacement property.
Under the final regulations, the following timing requirements apply for Section 1031:
- Identification: Property to be received must be identified within 45 days after it is given up in the exchange and transferred under one of these three methods:
- Three-property rule: Allows property owner to identify up to three properties as potential purchases, regardless of its market value.
- 200% rule: Allows property owner to identify unlimited replacement properties as long as its cumulative value does not exceed 200% of the value of the property sold.
- 95% rule: Allows property owner to identify as many properties as they would like as long as they acquire properties valued at 95% of their total or more.
- Receipt: Property must be received by the earlier of:
- 180 days after the transfer of the property given up in the exchange, or
- The due date, including extensions, for the tax return for the tax year in which the transfer of the property given up occurs.
- Reverse exchange: It may be possible to acquire the replacement property before selling the property to be exchanged and still qualify for 1031 treatment. The replacement property would need to be transferred to an exchange accommodation titleholder and a qualified exchange accommodation agreement must be signed. The same timing requirements would still need to be met (i.e., identify property for exchange within 45 days and complete the transaction within 180 days).
Additional Tax Considerations
These additional factors should also be considered related to Section 1031:
- Value of the new property. In order to receive full benefit of a 1031 exchange, the property owner’s replacement property should be of equal or greater value. If the value of the replacement property is less than the value of the property sold, the difference is considered “cash boot” and is taxable.
- Gains treatment in the transaction. If the transaction qualifies under Section 1031, any gain would be deferred until the like-kind property is later sold. However, there are instances where some gain would be triggered in the transaction, such as:
- Boot being received in the transaction (i.e., unlike property or cash), which becomes taxable. If liabilities are included in the transaction, the party relieved of the liability is treated as receiving cash in the amount of the liability.
- Expenses and fees may also be treated as boot and result in gain if they are financing fees, property taxes, repair or maintenance costs, or insurance premiums.
- Depreciation recapture rules still apply if there has been depreciation taken on property that is included in a 1031 exchange. Therefore, any taxable gain in the transaction would be taxed at ordinary rates up to the amount of the depreciation previously taken or allowed.
- Replacement property in the 1031 transaction does not have the same amount of property eligible for depreciation. For example, if you exchange improved real property (Section 1250 property) for land, Section 1250 gain could result since the land is not Section 1250 property.
- Qualified intermediary requirements. The property owner’s qualified intermediary cannot be a relative, or their attorney, banker, employee, accountant or real estate agent, or anyone who has served in any of these capacities for them within the last two years.
- Additional requirements. Property sold and replacement property in a 1031 exchange must be in the same business entity. The owner cannot sell property from one business entity and buy replacement property through another business entity to qualify for 1031 treatment.
Real estate investors seeking additional tax-deferral opportunities should also explore opportunity zones introduced by the TCJA. Opportunity zones is a tax incentive that offers three key tax benefits, including the temporary deferral of taxes on previously earned capital gains, a basis step-up of previously earned capital gains invested and a permanent exclusion of taxable income on new gains. Doeren Mayhew’s tax advisors work closely with clients to help them understand and navigate complex tax rules, such as Section 1031. To learn more about these exchange rules or to obtain an analysis on whether your property qualifies, contact us today.