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Section 1031 of the Internal Revenue Code (IRC) provides a way to defer the payment of capital gains taxes from the sale of a real estate asset and is one of the most powerful tools an investor can use to grow their wealth in real estate. This tool is available to anyone, but there are certain ownership and use requirements that must be met to utilize a 1031 exchange.
The first is that a property must be held for trade, business, or investment purposes, and be listed as an investment property on your tax return. The second requirement is that the property must have been owned for a minimum of two years prior to the sale so that it is treated as a long-term capital asset. When these two requirements are met, then a property would qualify for Section 1031.
There are certain investors and real estate assets that don’t qualify under these rules, and others that can be a hybrid of Section 1031 and other sections of the Revenue Code.
Developers and Fix/Flip
The first is an investor that would be considered a dealer/developer. Typically, developers don’t hold the property for the two years before sale, so wouldn’t meet the holding period requirements. But even if they do, the IRS considers real estate assets owned by dealer/developers to be their inventory, rather than investment properties. Along similar lines, investors that acquire the property with the goal of fixing and flipping it would not qualify for a 1031 exchange because they wouldn’t have held the property for investment purposes (Long term and intent to rent) or met the holding period requirements.
Primary Residence
A primary residence does not qualify for Section 1031 because it is not investment an property. Primary residences fall under a different section of the tax code, Section 121, that deals with the treatment of capital gains on the sale of a primary residence. You will occasionally see crossover between Section 1031 and Section 121 when the property is a multi-purpose property, or the use of the property is converted from a primary residence to an investment property, or vice versa.
Second Homes and Vacation Houses
Second homes and vacation houses can qualify for Section 1031, but there are additional rules that must be met. First, the assets will have to have been reported on prior year tax returns as an investment property. If it is reported as an investment property, then you can move to see if it would qualify under the use restrictions. Section 1031 requires the taxpayer to have owned it for twenty-four months immediately before the exchange, and within each of those two 12-month periods the taxpayer must have 1) rented the unit at fair market rental for fourteen or more days, and 2) restricted personal use to the greater of fourteen days or ten percent of the number of days that it was rented at fair market rental within that 12-month period. If the investor has met both of these criteria, then the property would qualify for a 1031 exchange.
If you have any questions about if your property would qualify for Section 1031, please contact us to discuss how the rules would apply to your specific situation and to discuss the potential for a 1031 exchange.
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