When the U.S. Congress passed its Tax Cuts and Jobs Act in late 2017, one of the many changes to the tax code was a change to the 1031 exchange, also known as a like-kind exchange. A 1031 exchange, named for the Internal Revenue Code Section 1031, allows investors to defer taxes from the sale of an investment property by reinvesting the proceeds in a new investment property.
Traditionally, exchanges were allowed for all types of investment property, including machinery, equipment, art and airplanes. But the new tax law repealed exchanges for personal property, and they are now only available for real estate property or real estate investments.
“All real estate is exchangeable if it has been held as an investment property," said Keira Rawlinson, Certified Exchange Specialist®, and manager of City National Bank's 1031 exchange qualified intermediary service. “That could include a building used for your business or a condo you've rented out for income."
When a business owner sells a piece of business real estate or an investor sells a rental property, he or she usually incurs an array of tax liability. That includes federal capital taxes, which can be up to 20 percent of the capital gains, and depreciation recapture taxes, which is 25 percent. In most states, investors are also charged state income tax, which can be another 10 percent or more.
“It's difficult to pinpoint the exact amount of taxes you can defer because it depends on state laws and the amount of depreciation that has been taken against the asset," Rawlinson said. “But most people are liable for taxes of about 30 percent to one-third of the proceeds of an investment property without doing an exchange."
A 1031 exchange allows investors to defer all the taxes they would have paid on the sale of an investment property by investing their net equity into another property of equal or greater value to what they sold. In many cases, buying a new property also can help meet the investor's needs, whether that's purchasing your company's building, or a rental property that earns passive income without requiring active management, Rawlinson said.
If you're seeking to defer taxes on the sale of an investment property, it's important to make sure you follow all the proper protocol to comply with IRS rules.
First, talk to your advisors to ensure that your property qualifies for an exchange. For instance, if you rent out a vacation home, but your own family uses it more than two weeks each year, the IRS may not view it as an investment property.
As a safe harbor, the IRS provides for taxpayers to work with QIs to protect their interests throughout the process of a 1031 exchange. At City National, Rawlinson is one of the few bank-based intermediaries. These professionals set up structures to securely hold funds from the sale of an investment property until they can be used for the purchase of a new property; your own attorney, accountant, realtor or another family member is not allowed to do this for you.
When seeking a QI, pay attention to security: In recent years, several QIs have operated Ponzi schemes, using the funds from clients' property sales to fund their own lifestyles.
The clock starts ticking on your 1031 exchange as soon as you relinquish the title for the property you're selling. From that point, you have 45 calendar days to identify replacement properties. You can list three potential replacements, or a number of replacements that total no more than 200 percent of the value of your relinquished property.
Also from the date of selling your relinquished property, you have 180 calendar days to acquire one or more of the replacement properties—and you have the option of exchanging the proceeds from one property into multiple new assets.
When your property exchange meets all the IRS requirements, you can defer indefinitely all taxes associated with the sale. And because a 1031 exchange is not a one-time-only option, investors can conduct them repeatedly to continue deferring capital gains taxes on property sales.
This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.
City National, as a matter of policy, does not give tax, accounting, regulatory or legal advice. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations and readers should seek professional advice. Please consult your tax professional regarding the possible tax consequences of a 1031 tax-deferred property exchange.