Can You Use A 1031 Exchange For A Personal Residence?
We all want to save money, and reducing taxes is a great way to do it. You have probably heard about the 1031 exchange. Many successfully use it to defer tax payments. But can you use a 1031 exchange for a personal residence? Let’s find out!
What Is It?
You must pay taxes when you sell the property and gain some. They can be high and sometimes cover up to 30% of the gains. But if you plan to invest this money to buy another property, you can avoid this payment. It is because you have a limited time to invest money into another property.
The 1031 exchange is especially advantageous for investors who frequently sell and buy property. It’s a great way to maximize revenue and minimize taxes. However, remember that this procedure doesn’t make the property tax-free; you’ll pay the required tax when you sell your new building.
This procedure can be challenging to understand for beginners. So, hiring a consultant is wise if you are an inexperienced investor. This way, you can avoid different troubles and costly mistakes.
Rules of 1031 Exchange
Such a process must have different rules and regulations. So, let’s see the requirements for real estate and procedures.
Like-Kind Property
You can replace the property you sell only with the like-kind one. It means you can sell a commercial building and purchase a residential one, but only to put it for rent. Generally speaking, all the real estate used for investment is like-kind from the law’s point of view. You can only apply this section if you buy private real estate or property in the USA.
Use for Business
You can use the real estate for business or trade purposes; the exchange doesn’t cover personal use of the building.
The Value of The Replacement Should be at Least Equal
The building or land you get instead of the sold one should be more valuable, or at least of the same value as the previous building. In other cases, you’ll have to pay taxes.
One Person Should Complete Both Operations
This requirement may be evident. However, in practice, there can be some confusion. Usually, they are related to the LLC. Remember that the owner can purchase the replacement in their name only in the case of a one-member LLC.
You Have 180 Days to Complete The Exchange
The term starts the day you sell the property. Then, you have to buy the replacement in half of the year.
You Have 45 Days to Find a Potential Replacement
You must find up to three variants of potential replacement in 45 days to be eligible for a 1031 exchange. Furthermore, you can select more than four real estate objects, but in this situation, their total price can’t be higher than 200% of the original sell price.
These two time periods run simultaneously, so you start counting when selling your property. For example, if you schedule a property replacement in 45 days, you only have 135 days to close the deal.
Rules for Loans and Mortgage
You may have cash left after the intermediary purchases the new property. In this case, the intermediary will pay you after 180 days. This cash, known as the “boot,” is taxable as a partial gain from selling your property. Consider this rule and be ready to pay the taxes.
One of the main ways people get into trouble with these transactions is by ignoring loans. It would be best to account for mortgages or other debt on the property you are giving up and any debt you have replaced. If you do not receive cashback, but your obligations decrease, this will also be considered income for you, just like cash.
Let’s say you have a $1 million mortgage on your old property, but your mortgage on the new property you get in return is only $900,000. As a result, you have a $100,000 profit that is also classified as “gain” and will be taxed.
Special rules apply when exchanging depreciable property. It may result in a profit known as a depreciation return, taxed as ordinary income. For example, if you change one building for another, you can avoid recapturing. But if you exchange improved land with a building for unimproved land without a building, you will return the depreciation you previously claimed for the building as ordinary income.
Because of these complications, you may need professional help when you do 1031.
Benefits of 1031 Exchange
If you know what to do, 1031 can be incredibly beneficial. Let’s consider all the advantages you have from using this article from the IRS.
Money Saving
Practically speaking, 1031 doesn’t eliminate the necessity to pay the tax. You’ll have to pay as soon as you sell the replacement property. But since the law doesn’t limit the number of exchanges, you can avoid paying for a long time.
Investment Consolidation
Managing several real estate objects is hard, especially if the maintenance is on you. So, many investors prefer to own one more prominent building and use the 1031 exchange to save on taxes.
Investment Diversification
If you don’t want to put all your eggs into one basket, you can sell one big building and purchase several smaller ones in different places. It will make your investments safer and ensure the diversification of your portfolio.
Using 1031 for Residential Property
You may have heard stories of taxpayers who used the 1031 clause to swap one vacation home for another, perhaps even for a home they wanted to retire in, and Section 1031 delayed income recognition. They later moved into a new property, made it their primary residence, and eventually planned to use the $500,000 capital gains exemption. The exception allows you to sell your primary residence and protect a $500,000 capital gain with your spouse if you have lived there for two of the last five years.
In 2004, Congress closed this loophole. So yes, taxpayers can still convert vacation homes into rental properties and make 1031 exchanges. For example, you stop using your beach house, rent it out for six months or a year, and then exchange it for another property. If you have a tenant and are businesslike, you’ve probably turned the house into an investment property, which should make your 1031 exchange okay.
However, this is probably not acceptable if you offer it for rent but never have tenants. Facts will be critical as time. The more time that passes after the conversion of the use of the property to a rental, the better. While there is no absolute standard, more than six months of fair use on a rental is needed. The year will be better.
Using 1031 to Buy a Home
You can’t move in immediately if you want to use the property you traded in as your new second or even primary home. In 2008, the IRS established a safe harbor rule, stating that it would not dispute whether a new home qualifies as an investment property for Section 1031. To comply with this safe harbor rule immediately in each of the two 12-month periods following the exchange, you have to do the following:
1. You must rent the property to another person for a fair rent of 14 days or more.
2. Your personal use of the accommodation can be 14 days or 10% of the number of days during the 12-month period the accommodation is rented out at a fair price.
What’s more, after successfully exchanging one vacation or investment property for another, you cannot immediately convert the new property into your primary home and benefit from the $500,000 exemption.
Before the law was changed in 2004, an investor could transfer one rental property in exchange for other rental properties, lease the new rental property for a specified period, move into the property for several years, and then sell it, taking advantage of the exclusion of profits from the sale of the primary location residence. Now, if you purchase a property under the 1031 exchange and then attempt to sell that property as your primary residence, the exclusion will not apply for the five years beginning on the date the property was acquired in a similar 1031 exchange. In other words, you will have to wait much longer to take advantage of the capital gains tax credit of the place of residence.
Conclusion
1031 exchange is a great way to save money on taxes, especially if your investments are significant. Unfortunately, the procedure isn’t that straightforward, and most beginners need professional help to manage all the stages properly. However, if you want to change the investment or business real estate you own, take advantage of the opportunity to save.
As for residential property and buying a home, this rule has limitations. You have to wait a long time and ensure fair commercial use of the building. Feel free to use the 1031 exchange if it’s not a problem.
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