Over the years, the U.S. Congress has been evolving the 1031 Exchange rules, and it can be difficult to keep up with. While they have removed several extremely beneficial rules in recent years, they have also introduced lucrative new opportunities. In this article we visit a few of these provisions to ensure you are able to maximize your commercial investments and answer the question “what are the rules of a 1031 exchange?”
Preferred 1031 Ownership Structures
If you are partnering with other accredited commercial real estate investors and want to qualify as a like-kind interest for the purpose of a 1031 Exchange, the two most common ownership structures that investors use are the Delaware Statutory Trust (DST) and Tenancy in Common (TIC).
TIC Structure
Because the Tenancy in Common Structure has been around for so long (dating back to the English feudal system of land tenures) it has been one of the most common 1031 ownership structures. However, the TIC has begun to fall out of favor in lieu of a more flexible alternative ownership structure.
DST Structure
The Delaware Statutory Trust has become the favored structure for multiple investors in a 1031 exchange. Private trust agreements form the structure where real property is “…held, managed, administered, invested, and/or operated.” Typically a professional real estate company, called a “DST sponsor”, will establish a trust where undivided fractional interest is held for the investors. The DST sponsor will also acquire the real estate assets for the investment.
One of the benefits of a DST is the lower investment entry required for a commercial real estate investor. This also allows investment capital to be diversified among multiple commercial real estate properties, thus reducing the overall investment risk.
TICs and DSTs
Both TICs and DSts are common ownership structures because of their efficiency and ease of use for each individual investor. The fact that these structures can be pre-packaged into turnkey investments have made them the most popular choices for 1031 like-kind exchange investors. The streamlined process also reduces the risk of violating the IRS 1031 timeframe regulations.
The Vacation Home Rule
Another well-known use of the 1031 Exchange rules concerns the tax laws around swapping vacation properties.
In past decades investors could more easily swap vacation homes under provisions of the 1031 Exchange Rule, due to reasons such as delaying recognition of gain. The investors would rent out the new property for a period of time, then move into the rental home as their primary residence. Later when they were ready to sell, they would utilize the capital gain exclusion (in combination with a spouse) to shield $500,000 in capital gain.
In 2004, Congress made the process more difficult by adding more restrictions to the vacation home rule with the passing of the American Jobs Creation Act of 2004.
One of the new requirements is that to sell their current home and benefit from the capital gain exclusion, the investors are required to first rent out the property for a minimum of 6-12 months to qualify it as a fair rental. Another limitation is that the gain exclusion is not applicable until five years past the date of property acquisition.
However, even with the added limitations, taxpayers are still able to benefit from the 1031 like-kind provision to purchase vacation home properties.
2018 Tax Legislation Changes
After the Tax Cuts and Jobs Act that took effect at the beginning of 2018, people are no longer able to use 1031 provision for personal property such as aircraft or franchise licenses. This completely eliminated both intangible and personal property from being considered a like-kind exchange.
Is important to understand that before this tax legislation changed the 1031 Exchange rules, exchanges of personal property, including aircraft, franchise licenses, intellectual property, patents, artwork, machinery, and other equipment, qualified for the 1031 like-kind exchange provision. However, this is no longer available for commercial property investors. Since early 2018, only commercial real estate and investments are included in the 1031 rules.
Qualified Opportunity Zones
One beneficial program that the 2018 act created was the Qualified Opportunity Zone (QOZ) incentive. These zones were designated to help specific geographic areas that would benefit from new developments and can be found not only in all 50 states but also U.S Territories. Simply put, investors are given tax breaks for pursuing commercial real estate investments in low-income areas, thus encouraging economic development.
A second benefit of investing in Qualified Opportunity Zones was negating any future value appreciation on QOZ investments. This capital gains liability elimination, combined with the 1031 Like-Kind Exchange deferment, can create impressive return incentives that are hard to overlook. If that wasn’t enough, there are four additional benefits to the QOZ program:
-
- The entire proceeds from the sale of an asset need not be reinvested, only the Capital Gains portion is required.
- Opportunity funds are able to be created in multiple Qualified Opportunity Zones, taking advantage of an increased number of investment opportunities while diversifying an investment portfolio. As long as the entity creating the opportunity fund is organized with the express purpose of investing in a QOZ and 90% of the fund is located in one of these zones, it will qualify for the Qualified Opportunity Zones program incentives.
- Sales made both inside and outside the Qualified Opportunity Zone may have their Capital Gains deferred.
- Precious metals, stocks, bitcoins, and other types of capital gains investments may qualify for QOZ investments.
- The entire proceeds from the sale of an asset need not be reinvested, only the Capital Gains portion is required.
Investors need to understand that many of the 1031 Exchange rules still apply to the QOZ program. This includes the 180 day time limit for investing capital gains, however it does remove the like-kind rule that a typical 1031 Exchange carries. With over 9,000 opportunity zones (at time of publication), taking advantage of this program has been a popular choice amongst commercial real-estate investors and has shown great benefit to development in low-income areas.
Taking Advantage of 1031 Exchange Rules
If you are interested in pursuing any combination of these incentives and capital gains tax deferments, we strongly encourage you to have a 1031 exchange guide. Please contact us before taking any concrete steps and we will help navigate you through the complexities and ensure that you make the most out of your investments without the risk of violating any IRS guidelines. Contact us at 866-293-1031 or info@preferred1031.com. We are happy to answer your questions and walk you through the process.