Humans have survived for hundreds of thousands of years thanks to our aptitude at conquering the elements, manipulating our environment and adapting to change. We have established communities and devised technologies and practices to protect us from environmental extremes and other threats, from the tiniest virus to the largest predator.
We have also devised methods for exploiting and cultivating resources to help us prosper and multiply and, in desperate times, undertaken extreme measures by uprooting our homes and traveling great distances in search of a better chance at survival. Or, sometimes we have stayed to defend our homes.
Most of us are familiar with the truism about constant change, attributed to Greek philosopher Heraclitus. In this era of outsized cultural, political, environmental, social and technological disruption, it seems truer than ever. Although change is the norm, often it takes us by surprise, potentially causing suffering to those who do not expect or prepare for change.
In recent years, we’ve seen how swiftly the pandemic disrupted long-standing patterns of real estate supply and demand for investors, lenders and homeowners. Millions fled urban areas for small towns, coastal regions, lakeside retreats and mountain communities, turning temporary escapes into permanent residences.
From extreme weather in the southeastern United States like Hurricane Helene and Hurricane Milton to massive wildfires in southern California and elsewhere, billions of dollars in property damage, injury and death have been caused across several states in recent years. Sudden change can impact our ability to respond rationally and lead to poor decision-making that escalates mere uncertainty into actual risk.
Perhaps it is time to reflect on lessons learned from such events and develop strategies to manage risk before the next big shift. For investors anticipating the next mass disruption, especially those wishing to avoid areas impacted by environmental changes, now might be the time to identify new locations where they may wish to live and work.
Using Section 1031 exchanges
Real estate investors wary of the next cataclysm might consider acting before it happens by implementing Section 1031 exchange strategies now to purchase vacation properties and second homes and possibly secure their place beyond the reach of its worst effects, while deferring capital gains tax and depreciation recapture.
“Mortgage originators with a basic understanding of exchanges and a referral network of exchange professionals can prove invaluable resources for both borrowers and lenders.”
Generally, personal-use property such as a second home or vacation home does not qualify for Section 1031 exchange treatment because only real property held for productive use in a business or trade or as an investment may be exchanged. Second homes and vacation homes also are not eligible for the personal residence exclusion under IRS Code Section 121, which currently allows a tax exemption of $250,000 for an individual and $500,000 for a married couple upon the sale of a primary residence.
How can an investor use a Section 1031 exchange to purchase a second home or vacation home if a personal-use property is not exchangeable? By purchasing the property with the intent to hold it as an investment and limiting their personal use of it to the greater of 14 days or 10% of the number of days during the year for which the property is rented at a fair market value.
Conversion opportunities
Few exchangers who purchase a vacation home or second home as an investment property in an exchange are aware they can convert its use to a primary residence without invalidating the exchange.
An exchanger can accomplish this by waiting at least one year after the exchange ends before moving in (the more conservative approach is to wait two or more years). At that point, the exchanger can occupy the property as a primary residence indefinitely or sell it and move on. If the exchanger owns the property for five consecutive years and has lived in it for at least two of those years, they can sell it and receive the benefit of the primary residence tax exemption under IRS Code Section 121 noted above.
Alternatively, the exchanger may move out and return the property to a qualified use, such as for business or investment. After using the property for a qualified purpose for at least one year, the exchanger might sell the property in a new exchange and once again defer tax on the gain and depreciation recapture.
Other exchange strategies
A business owner may sell their place of business and lease it back while planning a move to a safer location. They can exchange into a new building to occupy or lease, or even use a construction exchange to acquire land or a building and complete improvements within the safe-harbor 180-day exchange period. Once finished, the new property can be used for their business or rented to a tenant.
If an exchanger already owns land in a safe zone and has other qualified property to sell, they can use a construction leasehold exchange to construct improvements on the land, where the value of the improvements would be the replacement property for the exchange. Then, they can operate their business from there or lease it to others as an investment.
Note that exchanges (including construction exchanges and construction leasehold exchanges) can be structured as reverse exchanges, where the replacement property purchase occurs before the relinquished property sale.
An exchanger might not only wish to escape an area vulnerable to weather extremes, but to lessen the environmental impact of their replacement property by purchasing or constructing an energy efficient or Leadership in Energy and Environmental Design (LEED) certified building. In addition to enjoying tax-deferral under Section 1031, these exchangers also might benefit from accelerated depreciation and tax credit programs offered by state and federal governments for the purchase of investment and energy efficient assets. Or, they might purchase raw land to hold for appreciation and for carbon offset purposes.
Mortgage originators with a basic understanding of exchanges and a referral network of exchange professionals can prove invaluable resources to both borrowers and lenders.
There are many property owners who might benefit from a Section 1031 exchange, but do not know they exist. Even owners familiar with them often can be put off by their complexity or misled by inaccurate information they hear from others or read on the internet. Lenders sometimes avoid or lack experience in financing replacement property for exchanges, especially for complex exchanges such as reverse and construction exchanges where loan documents must be drafted so that the exchange will not default the loan.
A knowledgeable mortgage originator can differentiate themselves from competitors by helping borrowers and lenders understand what to expect when the loan involves a borrower doing an exchange and making referrals from a strong network of exchange professionals.
A Section 1031 tax-deferred exchange is an efficient tax mitigation strategy which sophisticated real estate investors have employed for decades. However, taxpayers may fail to fully realize its numerous benefits and potential applications to their investment strategies, even as they anticipate the next major disruption, be it natural disaster or otherwise. Mortgage originators with a fundamental understanding of exchanges and a solid referral network of exchange professionals, including Qualified Intermediaries, can prove invaluable resources to both borrowers and lenders.
