Held for Investment: 1031 Exchange Series Part Two

Held for Investment: 1031 Exchange Series Part Two

In the first part of our seven-part series on 1031 exchange basics, we discussed the six basic requirements. The first of those six requirements state that the real estate must be held for investment. In this, the second part of our series, we will discuss what held for investment means, what property qualifies, and how the holding period can be determined.

Held for Investment

This requirement states that in order to qualify for a 1031 exchange, the real estate must be held for investment. It’s vital to remember that this is different from section 121, which refers to your primary residence. With a 1031 exchange, we’re discussing investment real estate. That means we’re not concerned with the type of property as much as the use of it. Overall, the use of the real estate is what’s most important.

There are three different types of uses that qualify under the held for investment rule. This includes uses for trade, business, or investment. You can read more about each of them below.

  • Trade
    This means that you are holding the real estate for productive use in trade. For example, this could be a factory where you store or produce clothing if you’re a retail designer. If you work as a plumber, this could be a building where you keep items that you need for your trade such as toilets or pipes.
  • Business
  • Holding real estate for business purposes covers properties that you generate income off of. This may be an apartment complex that you rent out to tenants. It could also be a shopping center where you lease out space to businesses.
  • Investment
    The final use that qualifies under the held for investment requirement is holding the property for investment purposes. This means you’re trying to garner the incremental increase in value as it relates to a factor over time. To put it simply, you bought the real estate to hold it while it appreciates or increases in value over time.

Investment versus Inventory

Most of us don’t think of real estate as inventory. But, this is an important concept to understand when dealing with IRS rules and regulations regarding 1031 exchanges.

While we spoke about investment property above, it’s important to note the mention of appreciation as an increase in value over time. This is a critical factor in separating investment from inventory.

You cannot purchase a property for $50,000, fix it up, and promptly sell it for $100,000 and defer the tax with a 1031 exchange. In this case, the IRS considers such flipped property as inventory. Since you purchased it with the intent to simply turn around and resell it at a profit, it does not qualify for a 1031 exchange.

However, if you purchased the property at $100,000, fair market value, and a few years later it’s worth $200,000, that is appreciation. By holding the property and allowing it to appreciate in value, it is considered investment real estate.

The first scenario does not qualify for a 1031 exchange but the second one does.

Property That Does Qualify

A 1031 exchange covers U.S. property for U.S. property with a few exceptions. These exceptions include the U.S. territories of Guam, American Samoa, and the U.S. Virgin Islands. For example, you could sell a property in the U.S. and buy a property in St. Thomas (in the U.S. Virgin Islands) and do a 1031 exchange. Even though Puerto Rico is a U.S. territory, you are unable to do an exchange between a U.S. property and one in Puerto Rico due to the way their commonwealth is setup. You are able to sell foreign real estate and buy foreign real estate using a 1031 exchange. However, if it is a U.S. property, only other U.S. properties or ones from Guam, American Samoa, and the U.S. Virgin Islands will qualify.

As a general rule of thumb, rental properties will always qualify since you are holding them to generate income. Raw land is also always an investment. This is because you’re investing in raw land, not because you expect to turn it for a quick profit. If it does happen to appreciate quickly, it’s up to you and your accountant to decide what the intent was when you bought it.

Examples of Held for Investment Exchanges

To understand this a little better, let’s look at an example. Let’s say you purchased a piece of raw land at an auction. Then, three months later, you are able to sell that land for three times the amount you bought it for. Would this qualify for a 1031 Exchange?

That depends. When you bought the land, did you know it was going to be worth that much more immediately? Did you buy the land primarily to resell it? If you answer yes to those questions, you would be flipping the land and therefore not eligible for a 1031 exchange.

But what if, as one of my clients experienced, you never put the land up for sale? What if you had already planted crops? Then, what if someone approached you and offered to buy the land? In this situation, my client clearly intended to hold the land for productive use. But then the local gas company identified his land as the perfect place for a distribution hub and made him an offer he couldn’t refuse. In this instance, he clearly intended to hold it for productive use so even though his intent changed and he sold it quickly, it still qualified for a 1031 exchange.

Another example would be if you owned a duplex that you bought a while back. Let’s say you now want to sell and go buy a vacation condo on the beach. You’re going to use the beach condo a little bit but you also want to rent it out. Can you do a 1031 exchange in this situation? Absolutely! This still qualifies as rental property that you intend to hold. Personal use does not disqualify it, although there are some IRS rules and regulations about that, too (https://www.biggerpockets.com/blog/vacation-home-1031-exchange).

Intent is Key for the Hold Period

Typically, the hold period that most investors use for 1031 exchanges is longer than twelve months. Now, there’s no magic to that, because there is no statutory holding period. In the past, if you held property for more than twelve months, you would automatically qualify that property as a capital gain “long term”. If this property was sold with less than a year’s ownership, you would pay ordinary income. However, that easier measure is no longer valid and it is very difficult to put a time period down now.

My best advice is that longer is better rather than shorter. This is because the keyword to the entire statue revolves around the single word of “intent”. You are going to sell property that it has been your intent to hold for productive use in trade, business, or investment. However, now you’re going to purchase a new property that you intend to hold for productive use in trade, business, or investment. That’s the basics of a 1031 Exchange.

In summary, there are two ways to demonstrate your intent to hold for investment as there is no statutory holding period. The first way is that longer is always better than shorter. The second way revolves around your past history. What have you’ve always done? Do you have a history of buying property and holding onto it and renting it? Then you’ve set up something to demonstrate what your intent is. And your established intent is key when satisfying the requirement that the property being exchanged for investment.

 

This article originally posted at: https://www.biggerpockets.com/member-blogs/12255/90843-held-for-investment-1031-exchange-series-part-two.

 

Learn the six basic requirements of a 1031 Exchange

The Six Basic Requirements of a 1031 Exchange

When you’re looking to keep your taxes working for your own benefit with a 1031 exchange, it’s important to understand the requirements that need to be met. There are six basic requirements of a 1031 exchange. All six of these must be met in order for a 1031 exchange to be successful. In the first part of our seven-part blog series on 1031 exchange basics, I’ll go over the six basic requirements.

The Six Basic Requirements of a 1031 Exchange

  1. Held for Investment
  2. 45 Day Identification Rule
  3. 180 Day Rule
  4. Qualified Intermediary Requirements
  5. Title Requirements
  6. Reinvestment of Cash / Equal or Up Rule

I can’t stress enough that all six requirements need to be met. Even if you meet five of the six, the 1031 exchange will still fail. This type of exchange is authorized in the tax code and overseen by the internal revenue service (IRS). While they do have to allow exchanges and follow their code, they don’t have to make it easy. That’s why it’s important to make sure you understand and have a plan in place to meet all six basic requirements of a 1031 exchange before you proceed.

Within the six requirements, you’ll find that there is a requirement for the type of real estate. You’ll also have to follow certain timing rules such as the 45-day rule and the 180-day rule. There is a requirement for the use of a qualified intermediary to assist in the exchange. There are also special requirements surrounding the title as well which include how the title must be held. Finally, you’ll have to make sure you meet the reinvestment requirements. This specifically deals with what you have to put back in, or reinvest, to make sure that you will get the full amount of tax deferral.

In this seven-part blog series on 1031 exchange basics, I’ll cover all of the six requirements. This includes what they are, how they work, and what you need to do in order to achieve a successful 1031 exchange. You can also find this information via the Video Training link at www.the1031investor.com.

 

This article first appeared on my Bigger Pockets member blog.

There are more ways to control your money than just receiving cash. Even funds held in escrow by your title company are considered yours and can constitute constructive receipt.

Constructive Receipt and 1031 Exchanges

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Protect Your 1031 Exchange – File for an Extension

If your 1031 exchange began in late 2019, you may need to file for an extension of your tax deadline. This is because the normal exchange period of 180 days will be shortened to your tax filing day (April 15th with out an extension) if your surrendered property closed between October 19th and December 31st, 2019. Therefore, it is important to remember to file for an extension in order to protect your complete 180-day 1031 exchange period.

Why does this happen? The regulations outlined in Section 1031 state, “The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”

To explain this a little better, your normal 180-day exchange period can be reduced if you began your 1031 exchange after October 19th, 2019. If you are unable to purchase a like-kind replacement property before the deadline of April 15th, you should consider filing a tax extension in order to allow yourself the full 180 days.

How this Works

For example, Mr. Jones sells Vista Apartment Complex as part of a 1031 Exchange on November 26, 2019. Although the 180th day after this sale of his relinquished property is May 24, 2020 – his tax filing deadline occurs before this and automatically becomes his 1031 Exchange deadline as well. By filing an extension to his tax return, Mr. Jones can extend both his tax filing deadline and revert his 1031 Exchange deadline to the full 180-day exchange period.

Therefore, if your relinquished property closed between October 19th and December 31st, 2019, it’s important to file for an extension on or by April 15th, 2020. This will ensure you don’t lose out on your full 180-day 1031 exchange period.

Resources

To determine if the exchange you initiated in 2019 has a 180 day deadline after April 15th, use my 1031 exchange deadline calculator at The 1031 Investor.

To get more information about how to file for an extension, check out the IRS website for complete instructions.

A Consolidation 1031 Exchange and Why You Need It

If you have several different investment properties, it may be beneficial for you to sell them and invest in a larger property with a consolidation 1031 exchange. If you have been focusing on single family rentals, for example, you may own quite a few smaller properties. But, this can leave you spread over a large area trying to maintain multiple locations. What if you could exchange all of those properties for one large unit such as an office building? The good news is, with consolidation 1031 exchanges, you can!

What is a Consolidation 1031 Exchange?

To put it simply, a consolidation 1031 exchange starts with the sale of investment real estate and ends with the purchase of investment real estate. As long as the property valuations work out, consolidation 1031 exchanges allow you to sell multiple units and combine their value into a larger purchase.

For example, if you have four single-family homes selling for $250,000 each, they could be sold and combined to purchase a property worth $1 million. This does require additional planning as the timing of your sales and replacement purchase must fall within the IRS mandated time frames. Coordinating extended and/or rapid closings with your purchasers and entering into a contract on your replacement property may require extra effort and negotiation.

Why do I need a Consolidation Exchange?

One of the main benefits of using a consolidation 1031 exchange is the deferment of taxes. Typically, when you sell your investment property, any gain is subject to taxation. Also, whether or not you took advantage of the available depreciation deductions while you owned the property, you will still be subject to “depreciation recapture” taxes. However, this is not the case when using a 1031 exchange.

Consolidation 1031 Exchange Example

Some clients of mine recently completed a consolidation 1031 exchange. They sold three properties in the Midwest and replaced them with one higher value vacation rental property in California. First, they identified both their replacement property. Then, they found a purchaser for all three of their original rentals. Then they sold the three original rentals over the course of three weeks. They purchased their replacement property just three weeks later. Not all transactions will happen as neatly or swiftly as theirs, but it is an indication of what advance planning can accomplish.

Consolidation Can Add Up

When you use a consolidation 1031 exchange, you can sell your investment real estate and purchase replacement investment real estate while indefinitely deferring payment of the tax that would normally be due on the sale. This can significantly increase your buying power as well as your opportunities for compound growth and reinvestment.

Airbnb and 1031 Exchanges

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https://www.biggerpockets.com/blog/closing-costs-1031-exchanges

Bigger Pockets blog

Wondering what closing costs can be included in your 1031 Exchange? Check out our latest article on the Bigger Pockets blog.

 

1031 Exchange Qualified Intermediary

1031 Exchange Qualified Intermediary – Local vs. National

Does it matter if you use a local or national 1031 Exchange Qualified Intermediary (QI)? Wouldn’t it be better to select someone you can meet in person? While some investors derive a sense of comfort from proximity, the closest QI may not be the right QI.

To carry out a 1031 Exchange, your QI must be in place before you sell your investment property. The geographic location of your QI is not a critical factor for either documentation preparation or real estate closings.

But what of your peace of mind? These are your hard-earned investment dollars we’re talking about.

No matter their physical location, your QI should be experienced, accessible and dependable. They should be able to guide you through the exchange process and help your exchange glide smoothly along. They should be responsive to inquiries and timely in their communication.

If you are buying and selling within your home city, a local QI should be familiar with that market. However, a well-versed national 1031 Exchange Qualified Intermediary may be better suited to help you carry out an exchange both locally and from state to state. Regardless, a QI with a significant history of successful exchanges may serve you better than one with the ability to drop by for a cup of coffee.

No matter what your preference, to qualify for a 1031 Exchange you must have your local or national QI in place prior to the sale of your investment property.

For more information visit the www.1031investor.com.

1031 Exchange: The Most Important Thing to Know

Using a 1031 Exchange to grow your real estate portfolio faster using Uncle Sam’s money is a strategy that has helped millions of investors.

But of all the things you need to know about a 1031 Exchange, the most important thing is that it must be in place BEFORE you sell your investment real estate. The moment you receive your sale proceeds, it’s TOO LATE and you will have to pay the tax. Many investors new to this tax deferral method have discovered this after their sale and paid for it – literally.

The great news is that even if you are closing tomorrow or don’t know when you will close, it is quick and easy to start your exchange. Once you know what title company will be handling the transaction, the exchange can be initiated on your behalf by your Qualified Intermediary (QI).

Initiating your exchange with a QI prior to your sale is a rule that is a critical thing to keep in mind as you continue to learn about 1031 exchanges. I hope you will use the free online resources here at www.the1031investor.com as you explore this option.

The Note Closers Show Podcast

Dave Foster on The Note Closers Show

Dave Foster was recently featured on The Note Closers Show with Scott Carson. Dave and Scott talked about the great benefits IRC Section 1031 has to offer. It allows investors to sell a property and reinvest proceeds in a new property while deferring capital gain taxes. They discussed some of the ways you can use this process to help you invest in real estate and notes, how it can be used even if you have owner financing and what kinds of investment properties qualify. Anyone can do a 1031 Exchange so long as the process and principles are followed.

They also talked about how to minimize the top five risks in note investing, return on investment vs. return on time, and the role of the borrower filing bankruptcy and how it creates an additional opportunity for a note investor, among other things.

Listen to the episode at iTunes, Google Podcasts or on your favorite podcast streaming service!