Posted by Elliot Kravitz, ATP

1031 Exchange Rules: Everything You Need to Know

1031 Exchange Rules: Everything You Need to Know

1031 exchange is simply a swap of an investment property for another. Since most swaps are considered sales, they are taxed. Meeting the requirement of 1031 will remove or reduce your tax obligations.

As a result, you can alter your investment without having a gain. With this, your investment keeps growing with the tax pushed forward. 1031 has no limit on the number of times you can do it. The gain from a real estate investment can be rolled over to another. While each swap comes with profit, you dodge the tax till you sell for cash later in the year. This means you pay tax once, and at a long-term capital gain rate.

For 1031 to be valid, the exchange must be of like kind. This means you can swap an apartment building for a cottage house. The rules are not stringent, and there is even the opportunity to exchange businesses. There are, however, many things to watch out for.

1031 provision takes care of business and investment property, although the rule might take care of the primary residence in some circumstances.

To qualify for a 1031 exchange, both properties must be in the U.S.

Rules Guiding Depreciable Property 

If you are exchanging a property that can depreciate, special rules apply. There is a possibility it triggers what is known as depreciation recapture – a type of profit. Swapping a building for another can escape this profit.

A situation that can trigger the profit is swapping improved land with a house for another undeveloped land without a structure. The depreciation claimed on the building will come off as ordinary income.

When you consider complications like this, you need help with 1031s. 

Changes to 1031 Rules

Before the onset of the new Tax Cuts and Jobs Act (TCJA), some personal property exchanges like aircraft, equipment, franchise, etc., could be counted as 1031 exchanges. With the new law, however, only real estate meets the specs

Delayed Exchanges and Timing Rules

An exchange happens when you swap one property for another between two parties. Like trade by barter, getting someone who needs exactly what you want to exchange is shallow. This delays most exchanges.

With a delayed exchange, there is a requirement for a qualified middleman that will be in the custody of the cash after the sale of the property. This fellow will use the money to buy the replacement property.

For a delayed exchange, two principal timing rule is essential:

45-Day Rule

 After the sale of your property, the middle man (not you) gets the cash. You are not qualified to receive the cash, or it disqualifies the 1031 arrangement.  

Within 45 days after the sale, you should delegate the replacement property to the middle man. You need to specify in writing the property you wish to acquire. According to Uncle Sam, you can designate three properties as long as one of them will eventually be closed.  

180-Day Rule

You should close any new property within 180 days of selling the old one. The two time period run simultaneously on closing the sale

Tax Implications: Cash and Debit

There might be cash left after the middle man acquires the replacement property. If this is true, the middle man pays you after the 18- period ends. The IRS refers to proceed (boot) from this sale a capital gain, which will be taxed as partial sales proceed.

There are many ways people might get into trouble with these sorts of transactions. Failure to consider loans is one common way. For any property you relinquish or any debt on your replacement property, you must go for mortgage loans. Not getting cash could reduce your liability, which is also treated as income, the same way as cash.

For instance, you had a mortgage of $2 million on an old beach house. For the new property you swapped, the lease was $1.7 million. Your gain, which is also called boot, is $300,000 and will be taxed.

In Conclusion 

1031 is an exciting tool used by skilled real estate investors to defer tax. It allows them to build wealth in the process. 1031 has many complicated parts translating to the fact that you are better off with an expert that understands the rules to prevent getting into trouble.

Elliot Kravitz, ATP
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