Section 1031 of the Internal Revenue Code provides for one of the single greatest tax benefits. It’s one that few people ever take advantage of. It applies mainly to real estate investors. But this story will present creative ways to make 1031 exchanges work for other types of assets as well.
Increasingly, 1031 exchanges are being used for alternative assets such as collectibles and fine art. A February 2, 2015 Wall Street Journal story
noted the growth in such tax-deferring transactions within the art world. As prices for collectible art have surged, so has the need for wealthy nvestors to manage their tax liabilities on such holdings.
You can execute a 1031 exchange on an asset as long as it’s for business or investment (not personal use). And you exchange that asset for a like-kind asset (i.e., oil painting for oil painting, gold coin for gold coin, house for house). As with so much of the applied tax code, there are many complications and confusions – such as what constitutes “like-kind” works of art. Are all paintings of a like kind? What about sculptures and ceramics? The law isn’t clear, the IRS won’t tell us in advance how it will interpret it, and tax professionals differ in their educated guesses as to how the IRS will interpret the law.
Here Are the Basic Rules of 1031 Exchanges
Normally, when you sell an asset that has appreciated in value, you’ll owe capital gains taxes. But by following certain guidelines set forth in Section 1031 of the tax code, you can use your gains to “trade up” to a new piece of art, a new home, or other asset. Through this process, you can defer capital gains taxes indefinitely!
With real estate, one of the basic rules for a so-called “1031 exchange” is that you must make an exchange of the old property for a new property. The new property must be of equal or greater value. And you must identify it within 45 days. You’re allowed an additional 135 days to close the deal and take possession of the new title. Both properties must be business or investment properties. (Your personal home can’t be involved.) You then roll your gains from the old property into the new property and owe no taxes. You can even designate up to three replacement properties to roll the proceeds of your old property into.
You can repeat this process again and again on future properties. Over time you could build up perhaps millions of dollars of wealth, which will not be taxed until you finally decide to cash out. In fact, you won’t ever have to pay taxes as long as you keep “exchanging” and never sell for cash.
To execute a 1031 exchange properly, you must not touch the cash proceeds of your sale. Instead, you need to hire a “qualified intermediary.” (These people are sometimes referred to as “exchange accommodators”.) The intermediary will hold on to the funds until you are ready to have him or her apply the cash directly to your next home (or other like-kind) purchase.
There are actually professional, qualified intermediaries who make their living navigating real estate investors through this particular area of the tax code. You can locate such a person through the Federation of Exchange Accommodators (515-244-6515; www.1031.org). Expect to pay $1,000 or more for such services.
The intermediary is doing little more than makework tax compliance. Such expenditures may seem wasteful, but they are necessitated by the IRS. A thousand bucks is still a small price to pay for sheltering hundreds of thousands or perhaps millions of dollars from capital gains taxes. If you don’t go through every step of the process according to IRS rules, an IRS official could nix your entire 1031 exchange. Do it right, and you’ll be able to legally skirt capital gains tax liabilities.