Real estate investing has traditionally been a reliable source of passive income and capital appreciation and an alternative avenue for investors looking to diversify their portfolios. IRC Section 1031 exchanges can be a valuable financial tool to help you save money (via deferred taxes) while simultaneously building wealth (via income maximization).
If you’re on the fence about conducting a 1031 exchange with your spouse or partner, this insightful guide will help you make the right decision and understand how it works.
Is Combining Incomes for 1031 Exchange a Good Idea?
When investing in real estate, lack of capital is usually the biggest obstacle for many. There are several opportunities in the market, but more real estate investors should be able to fund them. But does that mean you should let a good opportunity pass you by because you don’t have the money you need? Well, if the option is as good as you think, bringing your spouse on the board might be a salient idea.
By pooling your income to buy a 1031 replacement property, you can also share the burden of risk with your partner. Not to mention, combining your incomes will allow you to buy a larger property, thus maximizing the benefits of your 1031 deal.
Things to Know Before Executing a 1031 Exchange with Your Spouse
First of all, if you’re wondering whether it’s considered okay by the IRS to do a 1031 exchange together with your partner – yes, it’s legally allowed. According to the IRS, when someone transfers a replacement property to a Limited Liability Company (LLC) that is deemed a sole proprietorship, they don’t violate the Section 1031(a)(1) criteria that mandate that said property be held for investment or used in a business/trade.
So, the same logic applies to spouses: you can file a joint tax return on your 1031 investment. The IRS sees a married couple as a single economic unit.
There are other considerations I would like to note about how the 1031 exchange will work. For starters, think about exactly how the real property is being held. For example, real property can be a spouse's separate and sole property or jointly held as marital property.
The critical thing to remember is that “entity consistency” must be maintained by both parties involved in the transaction. This means that whichever entity is the seller must also be the same entity that buys the replacement property. Therefore, it would be best to determine how the property is held to ensure you’re not firmly breaking any rules.
Establishing how the title is held is also critical in ensuring compliance with the holding requirement. There must be proper identification of replacement property, which includes identifying it within 45 days; a formal exchange contract must be executed; and everything must be completed within 180 days.
Combining Your Income Sources for a Better 1031 Deal
Combining your income with your spouse’s is an excellent idea to facilitate purchases of an expensive replacement property. Here are some ways to do that:
Look at Your Current Finances
Understanding your current personal finances will pave the way for your future investment. Take a step back to understand your current investment strategy and look at your budgets to understand how much you want to invest. Then, start tracking and planning your expenses. Know your credit scores and understand what is behind your credit report.
Also, determine how much you can save and how much you need to save for 1031 exchange funds. This may require you to adjust your lifestyle to fit your needs, like changing your buying habits and reducing your car and home insurance payments, for example.
Open a Joint Checking Account
Even if you don’t want to combine all of your bank accounts, you can open one joint fund to support your real estate investing ventures. Remember that managing money as a couple takes crystal-clear expectations and communication. Discuss how you will need each deposit money into this joint account and how you’ll use it.
Since you’ll be using the funds to buy a replacement property, make sure neither of you has significant unpaid debts. Otherwise, creditors can go after the money in your joint account.
Once you open the joint checking account, switch your W2 direct deposits (paychecks) to this new account, so your new income directly flows into this shared pot. These days it’s easy to open a joint checking account online so that any spouse can do it. Based on this, you’ll still need to identify both parties.
Open a Joint Taxable Brokerage Account
Also, consider opening a new taxable brokerage account where you can contribute monthly. Decide on an equity strategy you’re both comfortable with and set it up in the brokerage account. You can set up your joint investing account based on buying a particular replacement property.
Real Estate Properties that will Qualify for 1031 Exchange
For a successful tax-deferred 1031 exchange, the property must be “like-kind” and meet specific criteria. Like-kind property is based on its characteristics or nature, not its grade or quality. This means you have access to a wide range of exchange-eligible fundamental properties. For example, industrial land can be exchanged for residential, and a vacant parking lot can be exchanged for an office building.
About this, you cannot exchange real estate for artwork, as it doesn’t meet the definition of like-kind. In addition, the property you choose must be held for investment, not personal or resale use. This typically implies a minimum of two years of ownership. Essentially, here are the criteria you have to meet:
Both properties must be in the US.
The replacement property must be identified within 45 days.
The exchanger must hold the new replacement property for rental, business, investment, or income-generation purposes.
The exchanger must use the relinquished property for rental, business, investment, or income-generation purposes.
The replacement property must be received within 180 days (or whenever the federal tax is due, including the extension, if earlier).
The qualifying properties are rental property, commercial property, apartment buildings, farmland, Delaware Statutory Trusts (DST), and oil, mineral, gas, water, and ditch rights.
Real Estate Properties that Don't Qualify for 1031 Exchange
Now that you know which real estate assets you can invest in, it’s equally important to know about the properties that don’t qualify for a 1031 exchange by the Internal Revenue Code regulations.
The principal residence, i.e., your personal property, does not qualify. Similarly, a property meant to be converted to a principal residence in the immediate future also doesn’t qualify as a replacement property. But if the property includes both business property and the main home, it may be sold, and the correct value may be assigned to the business segment. Farm property is an excellent example of this; it includes a working farm investment property and a place of residence.
If you have a vacation property that you rent out, you’re limited to 10% or two weeks of total time rented for personal usage. If you use it for more than these limits, that property will not be deemed an investment property. As such, it won’t qualify for a 1031 exchange.
A second home also doesn’t qualify as a like-kind replacement property. Although it can be rented out, if you use it for personal purposes more than 10% of the days or more than 14 days sublet (whichever is greater), it will be considered your second home for that particular tax year. Based on your usage, a vacation property previously considered a business rental can turn into a second home in any given tax year.
Partners own many business properties or small investments. If the title to a piece of real estate is in the name of the partnership (such as “Morgan Properties Partnership”), then that whole partnership must conduct the exchange; you can’t exchange the partnership interests. In other words, individual partners cannot exchange their interests as they are interested in the partnership venture, not the property.
Moreover, suppose the property is in the name of individuals, as “tenants-in-common,” for example. In that case, each partner may exchange their interest in the property or pay taxes as they wish. Partners can also use Section 761(a) to opt out of the partnership and qualify for exchanging their interest in the property. If you are an investor in a partnership, we highly recommend getting professional legal advice regarding tax implications before you go ahead with a 1031 exchange.
Any property held as inventory doesn’t qualify for a 1031 exchange either. This includes land developed for sale and properties specifically bought for resale. So, it would be best if you were mindful of this rule when your goal is to defer capital gains taxes.
Related Party Property
The IRS advises steering clear of purchasing replacement property from a related party, i.e., a member of your immediate family. This is different from entering into a 1031 transaction together with your spouse or unmarried partner. Suppose the exchanged property, however, is held for two years. In that case, the transfer of the relinquished real estate to a related party and direct exchanges between related parties are considered valid.
Note: Are youwondering how much you can invest in exchange property? As per the IRS, you can buy as many as three properties regardless of their fair market value – or any number of properties, given their cumulative value doesn’t go above 200% of the sale price of your original property.
Work with a Dedicated 1031 Advisor at Pivot Professional Partners
At Pivot Professional Partners, we can help and guide you through every step of your IRC 1031 exchange process. Whether this is your first exchange or you are already well-versed with 1031 exchanges, we are committed to making your experience as smooth as possible. We will fully understand the circumstances around your exchange and then closely work with you to help you meet your goals.
If you have any questions, call us at (561) 444-3371 or send us a message online.
IMPORTANT: While 1031 is considered a tax strategy, we are not tax advisors, and you should consult your tax professional before investing.