The term ‘section 1031 tax exchange’ found its way into the volatile real estate tax code in 1921. Since then, it has remained a pertinent issue in real estate investment talks. Some people have utilized it to their benefit while others fear using it, probably because they are not fully aware of what it entails and how they can go about it. In this article, we are going to shed some light on what a 1031 tax exchange is and the various factors that affect how you should use it.
What is a Section 1031 Tax Exchange?
In basic terms, a 1031 tax exchange is a process that allows you to swap one investment property for another. Some people refer to this deal as a “Like-Kind Exchange.” Once your exchange meets the 1031 requirements, there will be no capital gains on the investment hence you will be subjected to a limited or no tax at all. Read the full legal text here.
You can invest without being forced to cash out a deal using a 1031 tax exchange as it gives room for your investment to keep accumulating tax-deferred growth. You can use it as many times as you want on different pieces of investment properties.
Although each exchange may attract some significant profits, the agreement shields you from taxes until you sell the property for cash. Even when the time comes for a cash sale, the only fee that you will pay is the long-term capital gains tax which depends on your income.
Despite the smooth sailings that a 1031 tax exchange promises, here are some key facts that you should know about it, to avoid any pitfalls that may come in your way.
1. The exchange is only for business transactions
The numerous benefits that come with 1031 exchange may tempt you to use it for personal use. You may decide to exchange your residential property for another one. The truth of the matter is that you will not go anywhere with such a plan. 1031 tax exchanges are designed for investment properties only and do not have provisions that can cater to personal residential houses.
Like-Kind is a broad phrase associated with a 1031 tax exchange. The meaning of the statement like-kind goes far beyond how many people interpret it. The properties involved don’t have to be of the same kind. For instance, you can exchange a townhouse building with a bare piece of land. You can also swap a strip mall with a ranch. The rules of the 1031 tax exchange system are quite liberal. Even with the freedom that you enjoy, you will want to be extra cautious with the calculations that you make. Doing this will shield you from falling into pitfalls.
3. Delayed Exchange
Under intended circumstances, a 1031 tax exchange is all about two people agreeing to swap their properties. However, it is paramount to note that there is a slim chance of meeting someone who has the exact assets as you do. In fact, the property to be exchanged may not even meet some of your most fundamental requirements. In such a scenario, you can delay the transactions. For any delays, you must involve an intermediary through a Starker exchange. An intermediary will hold your cash and use it to “purchase” an alternative property for you.
4. Designate the replacement and close the sale
Still on the matters of a Starker exchange, once you have sold the property, the middleman will receive the cash. You cannot directly receive payment even if it is your property because this will end up breaking the 1031 agreement. The law also requires you to designate a replacement within 45 days after selling your property. During the designation, you must write to the third party or intermediary giving full details of the property that you intend to acquire.
5. There is no limit on the number of assets that you can designate.
According to the IRS, you can designate up to three properties on a condition that you will choose one of them as a replacement. However, the results of your valuation tests can also determine the number of acquisitions to designate. For instance, you may identify unlimited properties if the fair market value of the replacements does not go beyond 200% of the average fair market value of all the properties exchanged.
6. Complete the exchange within six months
Time factor also plays a role in determining when you should close on the new acquisition. You should close escrow on the replacement within 180 days (six months) after selling your old property. Keep in mind that the 45 days within which you are supposed to designate an alternate are a part of this time frame.
7. Remaining cash becomes taxable income
After the intermediary contracts a replacement property, there is a probability that some monies may be leftover. Spare cash is also known as, “Boot.” In fact, Failing to recognize debts, loans, and mortgages on both the property that you are selling and the one that will be a replacement can land you in financial trouble. If you are moving to a property that has a lower mortgage than what you had on your previous one, the extra amount is boot as well. Boot is part of the sales proceeds and is subject to capital gains tax.
8. Seek professional advice
Do yourself a favor and proceed with caution before swapping your investments. Put all of the above factors into consideration and check whether you can meet them. This article is not meant to be legal advice in any way manner or form. This article is merely an introduction to the concept of a 1031 tax exchange. Please consult with a professional 1031 tax exchange consultant for further advice.
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