As if COVID wasn’t enough, the recent fires in Grand County have been a game-changer for many.
Some who own investment property and second homes (they also rent) are wondering what the future will hold if tourism declines. Permanent residents who were affected directly by the fires are simply looking for a place to live and rebuild their lives. Regardless of where you fall in this spectrum, there is a lot to consider if you own Grand County property.
You may already know, the property values in this area have risen sharply in recent years — and even after the outbreak of the Coronavirus — they continued to climb.
We are hearing many Grand County property investors haven’t sold because of fear of the tax consequences of the capital gains they will have to deal with. Some think values will go even higher so are also holding on to their unused properties.
One reason we believe you may be sitting on a gold mine is a little known tax incentive called the 1031 Exchange option.
If you have ever considered selling your investment property, a 1031 Exchange, also known as a Like-Kind Exchange or Starker, is a swap of one investment/business property for another. If you meet the criteria of IRS code Section 1031, you will be able to defer the taxable gains yet get all the benefits of selling in a strong market.
For those looking at the big picture, you can do this over and over…and over again — each time realizing a gain, but avoiding the tax on the equity you have gained until some time in the far future. In other words, you can change your form of investment without really cashing out in the eyes of the IRS. You are rolling over the gain from one investment property to another…leaving you more money in your pocket as your investments continue to grow.
But that’s not all. Like-kind probably doesn’t mean what you think. You may be able to exchange raw land for an apartment building, or a ranch property for a strip mall. The 1031 Exchange rules are very liberal when it comes to investment and business properties.
These investment properties do not have to be in the same town, county, or state…although both properties must be in the United States.
Here’s where most people get hung up:
There is a 45-day rule for the replacement property designation. When the sale occurs, the money gained is left with an intermediary and you must only designate a replacement like-kind investment within 45 days…
The other “timing rule” relates to closing. You must CLOSE on that new property within 180 days from the sale of the old property. These two-timing periods run in tandem. That means that you start counting when the sale of your property closes, leaving you to find a replacement property up to 45 days later — then allowing you another 135 days (over four months) to close on the new property.
This is truly an investment step-up plan. A primary way people get into trouble with this exchange plan is they fail to consider loans. For example, if you had a mortgage for $500,000, but the new property is only $450,000. You will have $50,000 of gain and it will be taxed. This $50,000 is known as the “boot”.
Parnell Quinn of The Simple Life warns, “1031 Exchanges might seem new to you, but investors have been using this code for years to make their real estate investments grow and work for them. There are even ways of “exchanging” vacation homes, but the IRS criteria and rules are much narrower for these than simple investment properties. Here, more than ever, it will pay to deal with a professional when selling your property.”
Additionally, you can make your personal vacation home into an investment property to take advantage of this tax incentive if you do a little preplanning.
Here’s an example: Say you stop using your ski condo and rent it out for the majority of a year and conduct yourself in a business-like way (no low ball rent for a friend). You will have converted your personal property into an investment which should make a 1031 exchange acceptable to the IRS. This does not mean you can just offer it for rent. You MUST have tenants and they must pay a fair market amount on their lease. Although there’s no absolute time needed between when it’s personal property and when it becomes an investment property; the longer the better.
There’s even a “safe harbor rule” in place that allows you to eventually use your newly swapped property for your primary or secondary residence. There are specific stipulations on how this can be done, but we don’t go into details on that here.
Investopedia’s article from September 15, 2020, 1031 Exchange Rules: What you Need to Know and How Savvy Investors use 1031s to Defer Capital Gains and Build Wealth, offers you a place to start if you want to learn more.