I appreciate the analytical, business-like aspect of the 1031 exchange, and try to do a couple every year just to keep my chops up. I’d love to do more exchanges because sellers of investment properties have to re-invest to avoid capital-gain taxes. But it’s rare that you can find new properties locally that are a good enough buy to make it worth the trade.
But for those who can – here is a good article on the basics of the 1031 tax-deferred exchange, plus three extra points worth noting:
While you will always want professional guidance when doing this kind of swap, there are three things to have in mind from the start:
- Be aware of “passive liability.” In other words, if you have a $1 million mortgage, do a swap and acquire a property with a mortgage of $900,000, you have “gained” $100,000 in the eyes of the taxman. If you are buying and selling large investment properties, these gains can add up quickly.
- To “exchange” a vacation or second home, that home must be an investment property. If you are planning to swap a vacation home, you need to make the case that it is an active investment. Usually that means being able to show paying tenants for at least a year. To ensure that you do not swap an investment property for a primary residence, a 2008 IRS ruling created a “safe harbor” for dwellings in a 1031 exchange. To meet the safe harbor rule, in each of two years immediately following the exchange, the home must be rented to another person for 14 days or more, and you may not use the home for more than 14 days (or 10 percent of the total number of days the home is rented in a 12-month period).
- An exchanged vacation home cannot become a primary residence for purposes of taking advantage of the principle residence exclusion. Property acquired in a 1031 exchange is subject to a five-year-period of exclusion from the principal residence capital gains tax benefit.