Using a 1031 Exchange to Buy an Emerald Coast Rental

Section 1031 of the Internal Revenue Code lets an owner exchange real property held for productive use in a trade or business or for investment solely for other real property of like kind that is to be held for productive use in a trade or business or for investment, and recognize no gain or loss on the trade itself. Two points are easy to miss. First, the provision now reaches real property only. For exchanges completed after the end of 2017, furnishings, equipment, and other personal property that once traveled alongside a building no longer qualify. Second, the tax is deferred rather than erased, and the mechanism is basis, not forgiveness. The statute gives the replacement property the same basis the relinquished property carried, decreased by any money received and increased by any gain recognized on the trade. Because the new building keeps the old, lower basis instead of taking a fresh one at what the owner paid, the untaxed gain stays attached to the property and surfaces whenever the owner finally sells for cash rather than exchanging again.

The two deadlines, and when they start

Two deadlines govern a deferred exchange, and both start on the same day: the date the owner transfers the relinquished property. The first allows forty five days to identify replacement property in writing. The second deadline is not a flat one hundred eighty days. The statute closes the exchange period on the earlier of two dates: the one hundred eightieth day after the transfer, or the due date of the owner's return for the tax year in which that transfer happened, determined with regard to extension. An owner who relinquishes property late in the calendar year and does not extend the return can lose weeks off the back end of the window. That makes the extension question a first conversation with the tax advisor, not a last one. Because both periods run from the same start date rather than back to back, the identification window also consumes the opening stretch of the total time available.

Identifying replacement property

The identification has to be in a written document signed by the owner and sent before the deadline, either to the party obligated to transfer the replacement property or to another participant in the exchange who is neither the owner nor a disqualified person. Each property must be described unambiguously: a legal description, a street address, or a distinguishable building name. From there the regulations offer two counts. An owner may identify three properties without regard to what any of them is worth. Alternatively, an owner may identify any number of properties so long as their combined fair market value at the close of the identification period comes to no more than twice the combined fair market value of everything relinquished, measured as of the date those properties were transferred. Exceed whichever count applies and the regulations treat the owner as having identified nothing at all, subject to two narrow exceptions: replacement property actually received before the identification period ends, and identified property received before the exchange period ends when it accounts for nearly all of the value identified, a threshold the regulation sets precisely.

When personal use is in the picture

A dwelling the owner also uses personally raises a separate question: was it genuinely held for investment? Revenue Procedure 2008-16 answers it with a safe harbor, meaning the IRS will not challenge that holding requirement when the standards are met. For replacement property there are three standards, not two. The owner holds the dwelling for at least twenty four months immediately after the exchange. In each of the two twelve month periods that follow, the first beginning the day after the exchange, the owner rents it to another person at a fair rental for fourteen days or more. And in each of those same periods, personal use stays at or below the greater of fourteen days or one tenth of the days the dwelling was actually rented at a fair rental. Whether a rental is at fair rental turns on the facts and circumstances that existed when the rental agreement was entered into. Personal use is defined by cross reference to the tax code's vacation home rules, which count days used by certain relatives and days let at a bargain rate against the owner rather than for the owner.

Missing the safe harbor standards

Missing the standards does not merely thin out the file. The revenue procedure itself tells an owner who reported the transaction as an exchange in the expectation of meeting the standards, and then determines the dwelling did not meet them, to file an amended return and stop reporting the transaction under section 1031 if that is what the facts require. The safe harbor is narrow in the other direction too. It resolves only the held for investment question, and an owner relying on it still has to satisfy every other requirement the statute and the regulations impose. Meeting the standards is also not the only route to qualifying, since the underlying test remains how the property was actually held. It is simply the only route that settles the question in advance.

Who may hold the proceeds

Control of the money is the other place exchanges come apart, and the rule there is specific. Actually or constructively receiving money or other property in the full amount of the consideration for the relinquished property before receiving replacement property makes the transaction a sale rather than a deferred exchange. Receiving some cash or other property that is not like kind is a different outcome: gain is recognized to the extent of what was received, without necessarily defeating the rest. Either way the structural fix is the same, and it is the reason a qualified intermediary exists. Under the regulations that intermediary is a person who is neither the owner nor a disqualified person, who signs a written exchange agreement with the owner, and who then acquires and transfers the relinquished property and acquires and transfers the replacement property. That agreement must expressly limit the owner's ability to receive, pledge, borrow against, or otherwise obtain the benefit of the funds the intermediary holds. Note who is ruled out. Anyone who served as the owner's employee, attorney, accountant, investment banker or broker, or real estate agent or broker at any point in the two years ending on the date the first relinquished property is transferred counts as the owner's agent and is disqualified, although services with respect to section 1031 exchanges, and routine financial, title insurance, escrow, or trust services by a financial institution, title insurance company, or escrow company, are not counted. The advisors an owner trusts most can be the ones the regulations will not allow into the role.

The calendar problem on this coast

On this coast the exchange calendar collides with diligence that cannot be compressed. Whether a given address may be rented on short stays cannot safely be assumed from a town wide or building wide answer. It turns on that parcel's zoning, the local registration requirements that reach it, and the condominium or homeowners association documents recorded against it, each confirmed in writing for the specific parcel before an offer goes out. Doing that work for the first time on a property already named on a forty five day identification list is a poor sequence. Screening candidates before the relinquished property goes under contract, and raising the intermediary and return extension questions with a qualified intermediary and a tax advisor in the same stretch, leave more room to lose one candidate without losing the exchange. This article is educational only. It is not tax or legal advice, none of it is written to any particular owner's facts, and these rules change. Work through your own qualified intermediary and your own tax advisor before you sign anything, and bring both of them in before the property you intend to relinquish reaches the market.