Some investors have been able to take advantage of the tax benefits of a 1031 exchange for years. Others are new to the game and may wonder what all the fuss is about. They hear the phrase “we’re going to 1031 that” spread by real estate agents, lawyers, or other investors, but they may not be clear about what the process entails.
Simply put, a 1031 exchange allows an investor to exchange one business or investment asset for another. Under normal circumstances, the sale of these assets would incur capital gains taxes. However, if you meet the requirements of IRS tax code section 1031 (hence the name), you can defer any immediate capital gains tax. However, it is important to note that a 1031 exchange is not a tax avoidance scheme. Eventually, when you sell your business or investment asset and do not replace it with other “like” property, capital gains taxes will be due.
There are many nuances to a 1031 exchange, so it is always wise to seek the guidance of a professional with experience in such transactions. Still, if you’re curious about the basics, here are some things to know before trying a 1031 yourself.
Not for personal use
While it may be tempting to consider changing your primary residence and avoiding capital gains liability, a 1031 is only available for properties held for business or investment use.
There are some exceptions to the prohibition of personal use
Like most things in the IRS code, there are exceptions to the rule. While personal residences generally do not qualify, you may be able to successfully trade personal property, such as your interest in a common lease or a work of art.
The property exchanged must be “similar”
This is an area that sometimes confuses new investors. The term “similar type” does not mean “exactly the same”, but simply that the properties exchanged are similar in use and scope. While the IRS rules are liberal, there are many pitfalls for the unwary.
All exchanges do not happen simultaneously
One of the key benefits is that you can sell your current property and have up to six months to complete the acquisition of the “like” replacement property. This is known as a delayed shift. When you want to complete such an exchange, you will need the help of a qualified intermediary – the person who will hold the proceeds from the sale of the relinquished property and then “buy” the replacement property for you.
Time matters
The IRS is very strict when it comes to 1031 exchanges. While they allow you to defer taxes, they also keep you on critical time frames to do so. The first is known as the “45 Day Rule.” This rule requires you to identify your replacement property within 45 days of the sale of your surrendered property. Failure to do so will void the change and taxes will be due.
You can designate multiple replacement properties
To make it easier to complete a successful exchange, the IRS allows you to name more than one replacement property. Of course, this is also subject to strict limitations. You can name up to three as long as you close one of them within the required time constraints. Alternatively, you can nominate more than three if they meet a valuation requirement (the 200% rule).
Time matters (again!)
In accordance with their strict requirements, the IRS also requires that you close your replacement property within 180 days of the sale of your surrendered property. The clock starts ticking on the day you sell and runs at the same time as the 45-day rule.
Watch out for the boot
If you receive cash during your 1031 exchange, the value is known as “Boot”. Boot is immediately taxable as a partial capital gain. You can get booted and still have a valid exchange. It is important to understand that this will be considered a taxable event in the tax year of your exchange.
The boot also comes in other shapes
It is not just the cash that can be considered a boot. If, at the end of your 1031 swap, your debt debt decreases, that will also be treated as income for you and you will be charged the appropriate taxes.
Change your vacation home with caution
Although primary personal residences are excluded from 1031 exchanges, under certain circumstances you can successfully exchange a second home. To do so effectively, the property must be 100% rental property and your personal use cannot exceed 15 days per year or 10% of the number of days during the year for which the home is rented at fair market value. .
As with everything related to the Internal Revenue Service (IRS), there are many pitfalls for the unsuspecting investor. It is important to consult with a 1031 exchange professional before attempting to exchange to ensure you are not caught off guard.
