A common conversation with clients is how to minimize taxes on their investments. When it comes to business or investment properties, taxpayers may be hesitant to sell, even if the investment is turning out to be an unprofitable one, because doing so will mean paying a sizable capital gains tax. What other options are available? Taxpayers who are willing to stay in the real estate market could benefit from a 1031 exchange. This IRS provision allows taxpayers to postpone paying capital gains tax if that gain is reinvested into a similar property.
Of course, taxpayers must be advised that a 1031 exchange does not eliminate taxes—it simply defers it. This might be a profitable strategy if the taxpayer could benefit from delaying that capital gains tax until a future year when they will likely be in a lower tax bracket or have more available deductions to offset their taxes owed.
Three Options for Handling a Property Investment
Tax advisers may want to start the conversation by orienting their clients to the three main options for maximizing their return on a real estate investment:
- Hold: If the conditions do not seem right to sell or make an exchange, property owners can always hold onto the property. The question is whether they will miss out on better returns if their property is located in an area without much job growth and less favorable long-term income projections.
- Sell: If getting the cash now or offloading the property is the main objective, the property owner can always sell and simply pay the capital gains taxes owed. This might be the best course of action if the taxpayer wants to shift their net gain into other types of investments. However, taxpayers may find it difficult to achieve the same return on investment with after-tax dollars outside of real estate.
- 1031 Exchange: Lastly, to defer paying those capital gains taxes, taxpayers can consider an 1031 exchange and trade one property for a “like-kind” property. This can allow the taxpayer to use their equity to purchase a larger replacement property, improving their investment portfolio while delaying taxation.
Qualifying for 1031 Treatment
Individuals, C corporations, S corporations, partnerships, limited liability companies, trusts, and other taxpaying entities may all qualify for a 1031 exchange. The IRS fact sheet provides this guidance on determining what type of property exchange qualifies: “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind, which is to be held either for productive use in a trade or business or for investment.”
This concept of “like-kind” property does not mean that the properties need to be identical or even similar in quality. Any real estate asset may be considered “like-kind” to another if both properties are held for business, productive use in a trade, or investment. For instance, an apartment building could be considered like-kind to an industrial property if both were purchased and held as business properties. Under this definition, most investment properties are going to qualify. If your client bought a rental property and receives rent from tenants, that property will likely qualify even if there are times when the property sits vacant.
On the other hand, property that is primarily “held for sale” does not qualify for 1031 treatment. In short, if you are functioning as a property dealer or developer, your properties will not likely qualify for a 1031 exchange. Any of the following could factor into whether a property is considered held for sale:
- The purpose for which the property was initially acquired
- The purpose for which the property was subsequently held
- The purpose for which the property was held at the time of sale
- The extent to which improvements were made to the property
- The frequency, number, and continuity of sales
- The extent and nature of the transaction involved
- The ordinary course of business of the taxpayer
- The extent of advertising, promotion, or other active efforts used in soliciting buyers for the sale of the property
- The listing of property with brokers
Exceptions to the Rule—Proving a Change in Intent
As usual, there may be some exceptions to the rule. A property could be held for sale and still qualify for 1031 treatment if the owner could prove a change in the purpose of the property. An example of a failed attempt to make such a case is Allen v. United States. Allen owned a property with partners, and his “purpose for which the property was initially acquired” was to develop the property and sell it. In fact, he did sell the property to a developer and attempted to apply 1031 treatment. However, when the IRS discovered that it was a developer status property, the agency determined that it did not qualify for 1031 treatment. Allen appealed the decision but was not able to provide evidence that he had changed his intent before selling the property.
So how might a property start out with dealer or developer status and still qualify for a 1031 exchange? If Allen could have proved with documentation that his intent had changed, he might have been able to win his case. Say he had written a letter to his attorney about intentions or changed the type of insurance he had on the property. This could demonstrate that there was a shift in the intended use. The same could be true if Allen had started collecting income by renting out the property or posted an advertisement to rent the property or sell it as-is. Some form of official communication that shows that the purpose of the property changed before the date of the sale could be sufficient to secure 1031 treatment.
Summary
If your client purchased real estate for business or investment purposes and is looking to shift to a more profitable investment, a 1031 exchange could be the strategy they need. If the taxpayer is willing to stay in the real estate market, this benefit allows property owners to make a trade for a like-kind property and this defer the payment of capital gains taxes. To deepen your knowledge on the tax benefits available for investments, sign up to become a Certified Tax Planner today.
