1031 Exchanges | An Introduction
If you’re afraid of getting hit with a huge tax bill after the sale of an investment property, then you should know about the tax deferring tool known as a 1031 exchange.
While 1031 exchanges can be used for various forms of assets, this article will focus solely on real estate. What you need to know:
1: A properly executed 1031 exchange can enable you to exchange one eligible property for another without triggering a currently taxable event as the 1031 exchange will allow you to defer your recognition of gain to a later date. There is no limit on how many 1031 exchanges you participate in.
TWO: Only the owner of the property can participate in a 1031 exchange, whether that property is owned individually or through an entity.
3: Only eligible property held for investment or use in a business can be exchanged. Residences and other personal property do not qualify. Vacation homes generally do not qualify, except in extremely limited circumstances.
4: It is very important to know that you cannot simply sell your original property and then use those funds to buy the new one — you have to formally “exchange” for the new property and there are very specific requirements and procedures you must follow to qualify, including the use of a “qualified intermediary” to facilitate the transaction. If at any point in the process you have access to the funds yourself, tax deferral will not be available. The easiest method to do this is to sell and buy the new property simultaneously, but more commonly you sell your property first and then buy a replacement property in a separate transaction to which very strict deadlines apply:
You have 45 days from the time you sell the first property to identify one or more potential replacement properties. You have 180 TOTAL from the day you sold your first property until the closing of your replacement property or properties. Timing is important. There are several other variations of a 1031 exchange including a “reverse” exchange (buy replacement property before selling.
You have 180 TOTAL from the day you sold your first property until the closing of your replacement property or properties. Timing is important. There are several other variations of a 1031 exchange including a “reverse” exchange (buy replacement property before selling).
There are several other variations of a 1031 exchange including a “reverse” exchange (buy replacement property before selling original property) or a “build to suit” where you can construct or improve a replacement property, but these involve considerably more complexity.
FIVE: The replacement property must be “like-kind.” For exchanges not involving real property this can get more complicated. However, the IRS is more forgiving when it comes to real estate -you can typically exchange any type of real property for another (including residential for commercial, building for land, one property exchanged for 2 or more properties, etc).
6: For complete tax deferral, a rule of thumb is that you should try to find replacement property for an equal or greater value than you sold the original property and subject to equal or greater debt. If you end up with leftover cash during the exchange or a relief of debt in the process (due to the replacement property being cheaper than the original) it may be taxed.
SEVEN : Even in the most basic scenario, a 1031 exchange is a very complex transaction with many moving parts and you need to plan accordingly and well in advance. A 1031 exchange isn’t always the optimal strategy and every individual situation is different so you must discuss your own with your tax and financial advisors to understand all the implications.
Terms to Know | 1031 Language
Down Leg — this refers to the process of selling your existing property • Up Leg — this refers to the process of buying the replacement property
Boot — any property that you might receive from the exchange that is not “like-kind” and therefore taxable — cash is one of the more common forms of “boot” but there are very commonly other unintended factors that apply.
Like-Kind — the property you exchange must be similar in nature. However, for real estate exchanges, “like-kind” generally refers to any eligible real property.
Qualified Intermediary — a third party who is employed to coordinate and facilitate a 1031 exchange.
For two case studies detailing how exactly a 1031 exchange works please see:
**This material is for informational purposes only.
This material does not purport to contain all relevant information on this topic and should not be relied upon or used in substitution for the exercise of independent judgment. Robert Rodriguez or Rodriguez RE Services, Inc. or Compass does not provide legal, tax or financial advice. Prior to making any decision regarding the information provided above, you should consult with your tax, legal and financial advisors.** |
KNOWLEDGE BASE 1031 Exchanges: An Introduction Helpful Resources: http://www.forbes.com/2010/01/26/capital-gains-tax-1031-vacation-home-personal-finance-robertwood.html