These Mistakes Can Sink Your 1031 Exchange Qualification
More and more investors are learning about the 1031 exchange.The 1031 exchange provides an extraordinary opportunity to escape capital gains tax on your real estate investment sales. As long as you comply with the rules of Section 1031 of the Internal Revenue Code, you can conceivably avoid capital gains tax indefinitely on sales of your investment real estate. But there are a number of very strict rules and, in practical situations, it’s all too easy to fall out of compliance and wreck your qualification status. Following are some of the most common reasons transactions end up being disqualified for Section 1031 benefits.
Offering Cheap Rent to Family Members
The 1031 exchange rules don’t prohibit you from renting out your investment property to family members or friends. Collecting rent from anyone deems it a bona fide investment. However, in order to avoid getting disqualified, you’d have to charge fair market value for the rental. That means no breaks of any kind for your beloved son/daughter, etc. The IRS may look closely at your 1031 transactions, so be sure to actually collect that fair market rent, too, so you can show receipts and deposits if you’re audited.
Duplexes are real property and so qualify under the 1031 exchange rules. But primary residences don’t qualify. If you’ve purchased a duplex or another multi-unit investment property and you plan to live in part of it while you rehab the other part, it then becomes a primary residence. This disqualifies your transaction for the 1031 exchange benefit.
Forming a Business Entity
One of the caveats of qualification is that the title of both properties must be in the same taxpayer’s name. So if you buy a rental under John Doyle, the purchase of your replacement property must also be in the name of John Doyle. Now, let’s say that you make a killing on your rentals and you decide to form a company out of this real estate investing business. You name your business John Doyle, LLC., because you’re aware of the IRS 1031 rule. But John Doyle the individual taxpayer is not the same as John Doyle, LLC., the taxpaying company. Come tax time, you’re going to owe the capital gains tax on the sale of that first property. Another scenario would be if you buy an investment property yourself and then you get married and decide to add your spouse to the title and then from there on out you purchase 1031 exchange properties in both your names. Be careful here, because technically you could be disqualified on the grounds that your spouse’s name wasn’t on the original title. The safest thing is to keep the names on all your titles identical, including spellings, nicknames and suffixes like jr. and sr. You can use any taxpaying entity you like, but it must remain constant throughout all your 1031 exchanges.
Let’s say that you and your loved one holiday in Belize and fall in love with a vacation rental property there. You can certainly buy it and maybe get a nice return, but it won’t qualify as like-kind under Section 1031. As stated by the IRS, “…real property in the United States is not like-kind to real property outside the United States.”
Disguising a Fix and Flip
The 1031 exchange is not permitted for fix and flips. It’s intended for investment properties; “real property held for productive use in a trade or business or for investment.” Now, real estate investors know that most investment properties need at least some rehab before they can cash flow. It’s fine to fix up your investment rental property so you can get the highest possible rent. What isn’t fine is to buy a distressed property, fix it up and then pretend to try to rent it out just long enough until you can flip it and do a 1031 exchange. First of all, the IRS is on to that trick. Second, this is the reason why most CPAs recommend holding your 1031 investment properties for at least a year before doing the 1031 exchange. Investors that attempt to circumvent the fix and flip exclusion will almost always regret it come tax time.
There are lots of rules regarding the 1031 exchange; many of them time-sensitive. While it may feel scary to attempt to do 1031 exchanges, remember that with the guidance of a qualified CPA and an intermediary, it’s perfectly safe and legal. Don’t miss out on this opportunity to defer capital gains tax indefinitely on your real estate investment properties.