Last updated on November 8, 2019 at 10:14 am
Are you a New Jersey landlord or invest in New Jersey rental properties? Here’s everything you need to know about like-kind exchanges of rental property.
First of all, what are like-kind exchanges?
Like-kind exchanges, also called 1031 exchanges, are a transaction (most frequently involving real estate although it can occasionally involve personal property) that allows a taxpayer to defer the capital gains tax that would have been due upon the sale of the asset (that is, the sale of the real estate).
This means instead of paying capital gains tax, the real estate investor can defer the capital gains tax on the sale of the appreciated property if they invest the proceeds in a new property. In the exchange, taxes are deferred — but if you later sell the replacement property, you will then have to pay capital gains tax (if there is a capital gain).
One alternative is to do another 1031 exchange with the replacement property and keep deferring the capital gains tax with each subsequent transaction.
The most common form of a 1031 exchange today is called a “Starker” exchange. It allows you to sell your property first and then buy your new replacement property at a later date. This “delayed exchange” makes more sense than anticipating a simultaneous swap of your original property for a replacement property.
Guidelines to consider
First, and most importantly, your personal residence does not qualify for a like-kind exchange unless it was used for your business. To qualify, the property exchanged must be held for investment or be used in a trade or in business.
Next, “like-kind” property is a residential rental or a commercial rental property located in the United States or the Virgin Islands. Remember — there are no geographic limits, so you can sell real estate property anywhere in the United States and then buy/exchange it for property anywhere in the United States, but if you are classified as a real estate dealer you are not eligible for 1031 exchanges.
Rental properties that qualify for a 1031 exchange include:
- A shopping mall and an undeveloped piece of land
- A condominium and a share of a cooperative
- Permanent conservation easements in two different pieces of real estate
- Water rights of unlimited duration
Thirdly, you must not have any access to the money from the sale of your property. This is strictly enforced and it means that when you sell your existing property, the proceeds are held in an escrow account for you until they are delivered to the closing where, upon completing the purchase, the agent deeds the new replacement property to you. Be careful though — because the closing on the new property must take place within either 180 days or by the due date of your next tax return — whichever comes first. There is an additional word of caution: you have only 45 days from the sale of your first property to identify the replacement property — and then you must close on your new purchase as described above.
Fourth, the replacement property must be of equal or greater value as the original property you are selling.
Under what circumstances does it make no sense to use a like-kind exchange?
You would not consider a 1031 exchange on rental property if the value of the property is less than your cost basis or if you have current year losses, loss carryovers or suspended passive losses that may offset the gain on the sale of the property either fully or partially.
Also, if you are in a very high tax bracket and need depreciation deductions, you must consider the fact that deferring any gain reduces the cost basis of your property and at the same time, your depreciation deductions will be reduced. If reducing depreciation deductions is not part of your plan, then this is not an appropriate strategy for you.
While this all sounds very complicated, it is not really difficult to transact a like-kind exchange. There are other details we have not put forth here, including strategies for buying down in value, using the 1031 exchange for mixed use rental/vacation homes, selling one property while exchanging it for multiple replacement properties or having an exchange between related parties — to name a few.
To be confident of the facts, please call your accountant or email me, Ken Bagner, at firstname.lastname@example.org. I will be delighted to help you.
Ken Bagner is a member of Sobel & Co. LLC. He is a member of the American Institute of Certified Public Accountants and the New Jersey Society of Certified Public Accountants. Plymouth Rock Assurance in NJ is proud to partner with NJCPA to bring you valuable tips for about your financial health. Qualified members of the NJSCPA can receive a discount on their car insurance through Plymouth Rock Assurance New Jersey.