Some investors have been aware of the tax benefits of a 1031 exchange for years. Others are new to the game and may be wondering what all the fuss is about. They hear the phrase “let’s 1031 do that” from real estate agents, lawyers, or other investors, but they may not be clear on what that process entails.
Put simply, 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 a tax liability on any capital gains. 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 don’t replace it with another “like-kind” property, you’ll have to pay capital gains taxes.
There are many nuances to a 1031 exchange, so it is always wise to seek the guidance of a professional experienced in this type of transaction. Still, if you’re curious about the basics, here are a few things to know before trying out a 1031 for yourself.
Not for personal use
While it may be tempting to consider changing your primary residence and avoid capital gains liability, a 1031 is only available for property held for business or investment use.
There are some exceptions to the personal use ban
Like most things in the IRS code, there are exceptions to the rule. Although personal residences generally do not qualify, you may be able to successfully exchange personal property, such as your interest in a joint tenancy or a piece of art.
The exchanged property must be “of the same type”
This is an area that sometimes confuses new investors. The term “of the same kind” does not mean “exactly the same”, but simply that the properties exchanged are similar in use and scope. While IRS rules are liberal, there are plenty of pitfalls for the unwary.
All exchanges do not occur simultaneously
One of the key benefits is that you can sell your current property and have up to six months to close on the “like-for-like” replacement property. This is known as a delayed exchange. When you want to complete such an exchange, you’ll need the help of a qualified broker – the person who will retain the proceeds from the sale of the relinquished property and then “purchase” 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 force you to meet critical deadlines to do so. The first is known as the “45 Day Rule.” This rule requires that you identify your replacement property within 45 days of the sale of your relinquished property. Otherwise, the exchange will be void 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 limits. Alternatively, you can nominate more than three if they meet a valuation requirement (the 200% rule).
Time matters (again!)
In accordance with its strict requirements, the IRS also requires that you close on your replacement property within 180 days of the sale of your relinquished 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.” The startup is immediately taxable as a partial capital gain. You can receive the boot and still have a valid trade. It is only 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 cash that can be considered bootleg. If, at the end of your 1031 exchange, your liability for the debt decreases, that will also be treated as income to you and you will be taxed accordingly.
Exchange your vacation home with caution
Although primary personal residences are excluded from 1031 exchanges, under certain circumstances you may be able to successfully exchange a second home. To do this effectively, the property must be 100% rental property and your personal use may not exceed 15 days per year or 10% of the number of days during the year the home is rented at fair value. market.
As with all things IRS related, there are many pitfalls involved for the unsuspecting investor. It is important to consult with a 1031 exchange professional before attempting to switch to ensure you are not caught off guard.