Some investors have been wise to 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 “let’s 1031 that” bandied about by realtors, attorneys or other investors, but may not be clear on what such a process involves.
Quite simply, a 1031 exchange allows an investor to swap one business or investment asset for another. Under normal circumstances, the sale of these assets would incur tax liability on any capital gains. However, if you meet the requirements of section 1031 of the IRS tax code (hence the name), then 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, capital gains taxes will be due.
There are many nuances to a 1031 exchange, which is why it is always wise to seek out guidance from a professional experienced with such transactions. Still, if you are curious about the basics, here are a few things you should know before trying a 1031 yourself.
Not For Personal Use
While it may be tempting to consider trading up your primary residence and avoiding capital gains liability, a 1031 is only available for property held for business or investment use.
There Are Some Exceptions To The Personal Use Prohibition
Like most things in the IRS code, there are exceptions to the rule. While generally, personal residences don’t qualify, you may be able to successfully exchange personal property such as your interest in a Tenancy-In-Common or a piece of artwork.
Exchanged Property Must Be “Like-Kind”
This is an area that sometimes confuses new investors. The term “like-kind” doesn’t mean “exactly the same” but merely that the exchanged properties be similar in use and scope. While the IRS rules are liberal, there are many pitfalls for the unwary.
All Exchanges Don’t Happen Simultaneously
One of the key benefits is that you can sell your current property and have up to six months to close on the acquisition of the “like-kind” replacement property. This is known as a delayed exchange. When you want to complete such an exchange, you will need the help of a qualified intermediary – the person who will hold the sale proceeds from the relinquished property and then “purchase” the replacement property for you.
The IRS is very strict when it comes to 1031 exchanges. While they allow you to defer taxes, they also hold you to critical deadlines in order 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 relinquished property. Failing to do so will negate the exchange and taxes will be due.
You Can Designate Multiple Replacement Properties
To make it easier to complete a successful exchange, the IRS permits you to name more than one replacement property. Of course, this is also subject to strict limitations. You can name up to three so long as you close on one of them within the requisite time limitations. Alternatively, you can nominate more than three if they adhere to a valuation requirement (the 200% rule).
Timing Matters (Again!)
In keeping with their strict requirements, the IRS also requires you to 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 concurrently with the 45-Day-Rule.
Beware The Boot
If you receive any cash during your 1031 exchange, the value is known as “Boot.” Boot is immediately taxable to you as a partial capital gain. You are able to receive boot and still have a valid exchange. It is just important to understand that this will be considered a taxable event in the tax year of your exchange.
Boot Comes In Other Forms, Too
It isn’t just cash that can be considered boot. If, at the conclusion of your 1031 exchange, your debt liability goes down, 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 can successfully exchange a second home. To effectively do so, the property must be 100% a 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 dwelling is rented out at fair market value.
As with all things related to the IRS, there are many pitfalls involved for the unwary investor. It is important to consult with a 1031 exchange professional before you try to swap to ensure you are not caught off guard.