A 1031 exchange refers to the real estate investment practice of swapping one asset for another asset held as an investment property. 1031 refers to the United States (U.S.) Internal Revenue Code provision and is the basis for this transaction. It’s also often referred to as a like-kind exchange.
Most asset swaps would be considered sales. The seller would thus incur the corresponding capital gains taxes (CGT). But if the real estate property you swapped for another qualifies as a 1031 exchange, you might not have to pay taxes on the transaction or just pay limited taxes. You can check out Peregrine Private Capital and other similar sites to learn more about how to do this.
Advantages Of 1031 Exchanges
The apparent advantage of the 1031 exchange is that real estate investors don’t have to pay CGT each time they swap like-kind properties. This allows them to exchange their existing asset for another one of a much higher price or value.
The long-term effect is that the investor can grow the value of their real estate investment over time because CGT doesn’t have to be paid yet with each transaction. Over time, it helps Americans accumulate and grow their wealth with real estate investments. Overall, this is good for the American economy since it generates more wealth and income and creates more jobs.
This can be enticing for those who invest in the rental property business since they can spend their money on projects that add value to their real estate property. They can make the most of whatever money they spend on their property because they’d be able to exchange it later on for another one without worrying about CGT.
What Does A 1031 Exchange Allow You To Do
The essence of a 1031 exchange is that it allows an investor to swap an existing real estate asset for another with a higher value without having to pay for the CGT. The idea is to roll over the gain from one property to the next to grow your investment over time.
There’s no limit to the number of times you can do a 1031 swap. You can gain money each time you make a swap, and you won’t have to pay the capital gain tax yet. You can do so only until you’re ready to sell your real estate property for cash and no longer exchange it for a like-kind.
How 1031 Exchanges Impact Rental Property Management
- 1031 Exchanges Entice Investors To Rent Out Property
One of the most critical impacts of 1031 exchanges on rental property management is that it will entice and, in some instances, even compel investors to rent out their property. For example, owners of vacation homes would have to rent out their vacation homes to qualify for the tax deferment.
In the past, Americans were allowed to swap one vacation home for another, and they didn’t have to pay any CGT. Section 1031 exchanges allowed them to defer tax payments. They could declare their most recent vacation house as their primary residence, then invoke their 1031 exchange shield and sell their primary residence without paying CGT. But they should have lived in their primary residence for at least two years out of the last five.
The U.S. Congress closed this loophole in 2004. Vacation property owners can still do a 1031 exchange, but they should first rent out their vacation house. They would have to show proof that they rent out their vacation property for at least six months or a year before they can be allowed to do a 1031 exchange.
The apparent impact on rental property management is that owners must ensure their property has tenants before invoking a 1031 exchange. This creates business for entities or individuals who provide rental property management services. The IRS would also disqualify someone from a 1031 exchange if they rent out their property, but it doesn’t get tenants.
- They Compel Investors To Rent Out For A Longer Time
Another impact of 1031 exchanges is that they would compel rental property investors to rent out their acquired properties for a more extended amount of time before they can invoke tax breaks. Under the new rules, an investor can’t move in right away to the property obtained in a 1031 exchange.
The IRS came up with a Safe Harbor rule in 2008. The IRS said it wouldn’t challenge the status of a property as an investment property for purposes of qualifying for a 1031 exchange as long as it meets the safe harbor requirements.
- To meet the safe harbor requirements, investors should rent out the property to another person for at least 14 days or longer within the two 12-month periods after doing the 1031 exchange.
- Investors should limit personal use of the investment property to no more than 14 days or not more than 10% of the total number of days covered by the 12-month period during which the property is rented out to third persons for an amount which can be considered as fair rent.
Another limitation is that the investor isn’t allowed to immediately convert the newly acquired investment property into their primary residence. This means the investor won’t be able to use the capital gain shield right away and invoke the USD$500,000 exclusion.
Before the 2004 change, rental investors could exchange rental property for another rental property, rent it out for a time, and then move in to say it’s now their primary residence. The investor could then claim exclusion of the gains from capital tax since it was a sale of a primary residence.
But the new rule imposed in 2004 doesn’t allow this scenario anymore. The investor could still do a like-kind 1031 exchange and move in to make the property their primary residence. But the investor won’t be allowed to invoke the exclusion of a primary residence if the property is sold within the five years from when the 1031 exchange took place. In other words, the investor has to wait for five years to pass before the property can be sold and claim the USD$ 500,000 exclusions.
The apparent impact of this is that investors are compelled to rent out their properties for a more extended period of time. They won’t be able to roll over their gains any time they want like they used to before the safe harbor and 5-year period rules took effect.
- Entice Investors To Make Property Improvements
A 1031 exchange operates like an incentive for property investors to spend money on improvements to their property. Under the old rules, property investors would be enticed to spend on improvements since they can keep the gain in value without having to pay CGT in the meantime when they roll over their existing property and swap it for another in a 1031 exchange.
In rental property management, this can be an incentive for property owners to keep making property improvements with each new 1031 exchange rollover. They’re enticed to invest in improvements because they know they’ll get to keep their investments with each 1031 exchange, and CGT won’t be deducted from their gain.
Under the new rules, it would have quite a different impact on rental property management. Investors would now be required to rent out their property before rolling it over. The effect is that more properties would be rented out because owners would now have to wait before they qualify for a 1031 exchange. This would spur more business for rental property management and entice investors to improve on their property in the meantime.
Another impact of the new rules is that property investors would now have to wait a little more before claiming the property as their primary residence. Investors used to do a 1031 exchange, claim the acquired property as their primary residence and then sell it to take advantage of the USD$500,000 exclusion from capital gain.
Under the new rules, though, they’d have to wait for five years before claiming it as a primary residence to avail themselves of the exclusion should they decide to sell the property. Investors would now be compelled to hold on to their properties for five more years. They would most likely be renting out such property for the next five years, thus adding to the rental property inventory in their area.
- The Impact Of Gain Limitations
The proposed changes to the 1031 exchange rules have also set a cap of USD$500,000 on all gains from the exchanged property. Any gain over USD$500,000 would now incur CGT under the proposed new rules. Investors would now make sure they don’t invest money in improvements, leading to gains above what they could shield under the exclusions.
This would also impact rental property management since there would now be less investment in property improvements. Overall, this would result in a decline in the construction quality of rental properties since there’s less incentive to invest in property improvements. They would most likely invest only in improvements to the extent that they could keep the gains under the exclusions.
Conclusion
A 1031 exchange isn’t exempt from the payment of taxes. Payment is just deferred until such a time that the property is actually sold and transferred by the investor in a transaction which isn’t a 1031 exchange. In a 1031 exchange, the gain in value wouldn’t incur any taxes and can be paid towards the final price of the new property. Under the proposed rules, though, there’s now a USD$500,000 cap on gains.
