Six things you need to know about §1031 - Part 1 For Investment Use Only

Section 1031 is an IRS code section that allows you to roll the gain from the sale of your Old Property over to your New Property.

To accomplish this, there are hoops you have to jump through, and the first of these is that both the Old Property you are selling and the New Property you are buying have to be held for investment or for business use. 1031 Exchanges allow the investor to defer paying any capital gains tax on the sale of their real estate. But it's NOT for your personal, primary residence -- it's only for investment or business use properties.

Your properties have to be real estate of course, but the "held for investment" requirement means that you can, say, sell a rental house and buy an office building, or an apartment building, or warehouse, or even bare land because all of these are investment properties. Also included as investment properties are second homes or vacation homes [1031 vacation home update: May 2007] if you can show investment intent (the IRS has a ruling that says this).

Section 1031 goes on to say that property "held for resale" does not qualify for a 1031 exchange. The classic example of held for resale is a "fix & flip." This does not mean that you can't buy distressed property and fix it up, but to defer the capital gain tax using Section 1031 you have to hold it for investment. The best way to turn fix and flip properties into investment properties is to hold them for at least a year and a day.

Where does the year and a day requirement come from? It is not part of the IRS code section, but it comes from a series of court cases that generally require a two tax year holding period. Two tax years means different things to different people. January 1st to January 1st is two tax years. So is July 1st to January 1st . And so is December 1st to January 1st . But the last example is not fair to the poor guy who bought his property way back in January. So the IRS has come up with the year and a day guideline as a way to level the playing field for everyone (a year and a day from any point in time will get you to another tax year -- even during leap year).

The other thing that the year and a day holding period does, is it keeps you from turning short-term capital gains into long-term capital gains by doing a 1031 exchange. Property held for at least a year is taxed at a much lower tax rate than property held less than a year. The theory is that the IRS is afraid that you might do a series of quick fix and flip type transactions rolling the gains over via Section 1031 and then decide a year later that you want to sell and pay the tax claiming that it must be long-term gain because you sold the last property more than a year after you bought the first property. The year and a day holding period prevents this.

A couple of final points... Both the Old Property and the New Property have to be located within the United States. And it is possible to sell one Old Property and buy several New Properties. Or sell several Old Properties and buy One New Property.

 

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