Some investors have been wise to the tax benefits of a 1031 exchange for years. Others are new to the game and may surprise 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 course of action 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 observe that a 1031 exchange is not a tax-avoidance scheme. ultimately, when you sell your business or investment asset and don’t replace it with another “like kind” character, 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 specialized experienced with such transactions. nevertheless, if you are disinctive 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 dominant residence and avoiding capital gains liability, a 1031 is only obtainable for character 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 character such as your interest in a Tenancy-In-shared or a piece of artwork.
Exchanged character Must Be “Like-Kind”
This is an area that sometimes confuses new investors. The term “like-kind” doesn’t average “exactly the same” but merely that the exchanged similarities 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 meaningful benefits is that you can sell your current character and have up to six months to close on the acquisition of the “like-kind” substitute character. 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 keep up the sale proceeds from the relinquished character and then “buy” the substitute character for you.
The IRS is very strict when it comes to 1031 exchanges. While they allow you to defer taxes, they also keep up you to basic deadlines in order to do so. The first is known as the “45 Day Rule.” This rule requires you to clarify your substitute character within 45 days of the sale of your relinquished character. Failing to do so will negate the exchange and taxes will be due.
You Can Designate Multiple substitute similarities
To make it easier to complete a successful exchange, the IRS permits you to name more than one substitute character. Of course, this is also unprotected to strict limitations. You can name up to three so long as you close on one of them within the required time limitations. Alternatively, you can nominate more than three if they to pay attention to a valuation requirement (the 200% rule).
Timing Matters (Again!)
jibe with their strict requirements, the IRS also requires you to close on your substitute character within 180 days of the sale of your relinquished character. 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 closest taxable to you as a uncompletely capital gain. You are able to receive boot and nevertheless 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 consequently.
Exchange Your Vacation Home With Caution
Although dominant personal residences are excluded from 1031 exchanges, under certain circumstances you can successfully exchange a second home. To effectively do so, the character must be 100% a rental character and your personal use cannot go beyond 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 specialized before you try to swap to ensure you are not caught off guard.