Disclaimer: This article is intended for informational and general overview purposes only. We are not tax professionals or attorneys, and this content should not be considered legal or tax advice. Tax laws and regulations change frequently, so please consult a qualified accountant or tax advisor before taking any steps related to a 1031 exchange.
A 1031 tax exchange allows investors to sell an investment property and “exchange” the profit or gain into the purchase of their next investment property. (In North Carolina, the 1031 Tax Deferred Exchange is also known as a Like-Kind Exchange).
Understanding all the requirements of Section 1031 of the Internal Revenue Service (IRS) before you cash in one investment for another is important. This way, you can follow the strict timeline, rules, and requirements needed to render your exchange tax-free.
What is a 1031 Exchange in North Carolina?
A successful 1031 Tax Exchange defers paying the taxes on the capital gains from the sale of a property. In simple terms, you’re swapping one property for another in the same or similar category and deferring capital gains tax.
While it sounds simple, this can be tricky in a tough buyer’s market where there are multiple offers on properties and/or inspections, repairs, and appraisals can be delayed. You will need the help of an experienced real estate agent to manage the many facets of selling and buying through a 1031 exchange.
What Properties are Eligible for 1030 Exchanges?
The IRS code specifies that your use of the property dictates whether it qualifies for a 1031 exchange. Your vacation or second home must be used for productive business, trade, and investment purposes in order to qualify for the deferment.
The good news is that you may identify up to 3 properties. You may purchase one, two, or three of those identified properties in the exchange.
Vacation and Second Home Eligibility
If your vacation home or second home property is used primarily for personal use it is ineligible for a 1031 exchange.
A few IRS rules to guide you for qualification include:
- Property must be owned for 24 months prior to selling
- in each of the 12-month periods prior to selling, personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at fair rental value.
(Note: This describes the IRS “safe harbor” rules (Revenue Procedure 2008-16) for qualifying a dwelling unit as investment property. It’s important to note that these are “safe harbor” rules, meaning if you meet them, the IRS won’t challenge the property’s qualification. If you don’t meet them, it doesn’t automatically disqualify the property, but it opens the door for IRS scrutiny.)
1031 Exchange Timing Rules
It’s also important to note that strict IRS 1031 Exchange timing rules dictate that to fully defer taxes, the replacement property must be of equal or greater value (meaning equal or greater net equity and debt) than the property being sold. If the gain is not fully reinvested (i.e., you receive ‘boot’ in the form of cash or reduced debt without an offsetting increase in equity), you will pay capital gains on that ‘boot’ portion.This is why a 1031 exchange is generally not a good tactic for downsizing if your goal is full tax deferral.
You also must know that you’re on the clock. You have:
- 45 days from the closing of your investment property to identify the next property
- 180- days from the closing of property one to the close of property two – the identified property.
If you miss either of these dates, you will be responsible for paying the full capital gains tax on the gains from selling property one! Use the link below to see the full 1031 exchange timeline.
Like-Kind Exchanges
It is important to understand what constitutes a like-kind exchange when identifying your replacement property purchase. As the name implies, the property being purchased must be the same kind of property that is being sold.
However, like-kind properties need not be exactly the same. Commercial, residential, undeveloped land, and developed properties are all like-kind to each other, so each is exchangeable with each.
In general, both must be business, productively used in a trade, or an investment. For example, farmland can be exchanged for farmland.
An apartment building can be exchanged for another, multi-unit rental building. Further, all these property types can even count as like-kind to fractional ownership interests in Delaware statutory trusts.
200% and 95% Rules
If you have more than 3 properties you want to consider, it is possible to complete the exchange through the 200% and 95% rules.
- The 200% rule allows you to identify more than three properties if their combined value does not exceed 200% of the relinquished property’s value.
- The 95% rule says you may identify any number of properties with no reference to the sale price of the relinquished property, provided you actually acquire and close on 95% of the value identified. Know that if you acquire less than 95%, then the entire exchange will be considered invalid.
Once you find that replacement property, it is identified on a document, signed by you, with a clear and recognizable description of the property(s). For example, it may include the full address, legal description, or distinguishable name. For example, you couldn’t just identify a development or an area. You must include the exact address.
1031 Qualified Intermediary
One of the rules of a 1031 exchange is that the transaction must be managed by a Qualified Intermediary (QI). In North Carolina, this is typically a specific 1031 exchange company. It’s crucial that the QI is an independent third party and has not been your agent, attorney, accountant, or employee in the two years prior to the exchange. A QI is a person or company that ensures the investor follows the rules of the 1031 exchange. In a 1031 exchange, the intermediary ensures all deadlines are met and that the investor does not have access to the proceeds from the original sale.
A qualified intermediary is a person or company that ensures the investor follows the rules of the 1031 exchange. The intermediary holds the funds from the original sale, ensuring the investor does not have constructive receipt of the proceeds, and facilitates the transfer of funds for the replacement property, ensuring all deadlines are met.
Passive Income Options with Delaware Statutory Trust
Up until recently, 1031 exchanges were a tool that allowed sellers to defer taxes on the sale of investment properties if they bought another, like property, with the proceeds and within a strict deadline. The IRS recently clarified how DSTs could qualify as like-kind property for 1031 exchanges in the Revenue Ruling 2004-86 to allow a new, passive income option called the “DST” (Delaware Statutory Trust).
Rather than purchasing another investment property to self-manage, investors can now exchange their relinquished property into beneficial interests in a professionally managed Delaware Statutory Trust (DST) that holds real estate properties. This provides a passive ownership option within the 1031 framework.
With this DST, exchangers can not only defer paying taxes on the gains from the property sale, but they can also earn returns (income and appreciation) on the investment via the portfolio. Only a handful of financial management companies or “sponsors” are offering this option so please speak with a licensed Financial Advisor if you are interested in finding out more about DSTs.
Filing a 1031 Tax Deferred Exchange in North Carolina
If you are looking to exchange your investment property in North Carolina and defer capital gains taxes, a 1031 tax-deferred exchange can be a powerful tool. Be aware that taking cash out of the exchange (known as ‘boot’) will trigger immediate taxation on that portion.
Be sure to engage the services of an experienced agent who knows the ins and outs of 1031 exchanges and Second Home/Investment properties!