The 1031 exchange got its name from section 1031 of the Internal Revenue Section. A 1031 exchange allows you to reinvest proceeds from the sale of a like-kind property into another like-kind property. This will enable you to defer the payment of capital gain taxes on the potential gains you may have made from the sale of your old property.
In this article, we will reveal ten (10) things you should know about the 1031 exchanges.
What Are the Top Ten (10) Things to Know About The 1031 Exchanges?
- How Your Investment Property Is Held Makes A Big Difference
Before a 1031 exchange can be possible, your old property must be held for investment, trade or business purposes. Certain types of properties such as LLC interest, partnership, stock, and certificate of trust are not eligible for use in a 1031 exchange.
- 1031 Exchanges Are Tax-Deferred, Not Tax-Free
According to Dwight Kay, founder and CEO of Kay Properties and Investments “A lot of people think and say that it is a tax-free exchange, but in real 1031 Exchange is a tax-deferred exchange. This is because the potential capital gain and the deprecation recapture must be paid to the IRS when the replacement property is ultimately sold (not as part of a 1031 exchange)”.
Now, if the owner of the property passes away while deferring gains, whoever inherits the property will get a step-up in basis and avoid paying all the accumulated deferred taxes. So, the tax does go away under this circumstance.
- You Must Exchange A Real or Like-Kind Property
To be able to defer capital gain taxes successfully, you must exchange real or like-kind property. Real or like-kind property is a property that is held for investment, trade, or business purposes. You cannot use your primary residence, but you can exchange a rental house, an office building, industrial building or retail building. The real property you are exchanging doesn’t have to be the same but of the similar class, nature, and character. That is, you mustn’t exchange an office building for another office building. You can sell an office building and exchange it for a multi-family apartment or even vacant land.
- 45-Day Identification Period
When you close on the sale of your old property, you have 45 days to identify a list of potential replacement properties and submit to a qualified intermediary. This identification period is a part of the IRS stipulated IRS 180-day timeline. There is no extension to the 45 days identification timeline.
- You Have 180 Days to Complete A 1031 Exchange
You have only 180 days to close on one or more of the properties you identified during the 45 days. The 180-day timeline starts right after you sell your relinquished property or old property.
- There Are Three Basic Identification Rules
Three basic identification rules are guiding the identification of real property for 1031 exchange. The first one is the three-property rule which is the commonest and involves you identifying up to three like-kind properties. The second is the 200% rules, and it requires you identifying properties with their total value, not exceeding 200% of the property that you are selling. The third rule, which is rarely used by investors is the 95% rule. It requires that you identify numerous properties, but you must buy 95% of the ones you identified.
- A Qualified Intermediary Must Handle the Exchange
You must use a Qualified Intermediary to handle the exchange, do the paperwork and hold the money from your sale of the relinquished property. The IRS stipulates that you must not touch or receive the money from the sale of the old property or your 1031 is disqualified. The QI, according to the IRS, must be an unrelated third party to the transaction. So, your attorney or accountant cannot hold the money on your behalf.
- Your Exchange Property Title Must Be Held the Same Way
Your exchange properties titles must be held in a property title. That is, if you held your relinquished property in the name of John Smith, the new property must be titled the same way. It cannot be John and Mary Smith.
- Reinvest Total Sale Proceeds
To defer capital gain taxes, you must reinvest all the proceeds from the sale of your relinquished property. In other words, you must acquire a replacement property that is equal or higher in value than the one you sold.
- Boot is Taxable
Any leftover cash from the purchase of your replacement property is subject to capital gain tax. This is known as boot. For example, if you sold your replacement property for $500k and purchased a new property for $400k, the extra uninvested $100k cash is taxable.