Things to Know About a 1031 Exchange

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Things to Know About a 1031 Exchange

The idea of doing a 1031 exchange and swapping one property for another while deferring the capital gains tax is intriguing, and many people want to know more about it. Here are some things about 1031 Exchanges that we think everyone should know:

1. 1031 Exchanges are for the exchange of like-kind property held for investment.In order to do a 1031 exchange, the old property being sold and the new property being purchased must be like-kind. This means that any real property used for investment or real property used in a trade or business can be exchanged with another real property used for investment or a real property used in trade or business. This also includes bare land. Properties that are claimed as personal use, or properties purchased with the intent of being a quick “flip” do not qualify for a 1031 exchange. As a general rule, we suggest holding onto your investment property for at least a year and a day before doing a 1031 exchange.

2. 1031 Exchanges are tax deferred, not tax free.When doing a 1031 exchange, you are deferring the taxes. This means you won’t be paying the taxes on the sale now. Should you decide to sell your new property at a later date, you will then have to pay the taxes you originally deferred. There are two ways of avoiding paying those taxes, though. The first way would be to hold on to the new property until you die. Like most investors though, you may decide one day to sell and purchase a new property. If you decide to sell and reinvest, you can use that property and roll it over to a new investment property through another 1031 exchange. By rolling your property over, you will still be deferring the taxes. Theoretically you can do this over and over until you die and never have to pay the taxes!

3. Timing is everything!1031 Exchanges are very time sensitive. Remember: the process of preparing the exchange begins before closing on the relinquished property, you have 45 days to identify a replacement property starting from the closing date of the relinquished one, and you have 180 days to close on the replacement property. One day over these time limits, and your exchange is toast!

4. You can designate, and even purchase, more than one property in a 1031 exchange.As part of the 45-day identification period, you are to designate up to 3 replacement properties. According to the rules of a 1031 Exchange, the replacement property must be one that you have identified on this form. Now let’s say you are an investor who is trying to build up their portfolio, and would like to use the funds from the sale of the relinquished property to buy more than one replacement property. This is definitely possible—as long as the properties were properly identified on their 45-day identification form. It is a great option for investors looking to build their portfolio, or someone who just can’t make up their mind on which replacement property to purchase!

5. Should you choose to identify more than 3 properties on your 45-day form, the 200% rule applies.
This is a situation we try and steer our clients away from, as it can get pretty messy. The 200% rule tells us that you can list more than 3 properties, but the total value of all properties listed must not exceed 200% (or 2X) the amount of the relinquished property. For example, if your relinquished property sold for $200,000 and you chose to list 4 properties on your 45-day form, the combined total fair market value of all 4 properties must not exceed $400,000.

Should the amount of the 4 or more properties exceed 200%, then the 95% rule applies. This rule means that you have to purchase 95% of the total value of all the properties that are listed. Let’s say you sold your relinquished property for $200,000. You decide to list 5 properties on your 45-day form, and the total combined fair market value of those 5 properties was $1,000,000. As you can see, that clearly is over the 200% rule, so now you would have to follow the 95% rule and purchase at least $950,000 worth of those properties. This would most likely require you to purchase all of the properties listed. Because of these two rules, we suggest staying within the 3 property limit to avoid falling into the 200% or 95% rule.

6. The person who holds title on the old property, must be the one who takes title on the new.
When taking title to your new property in a 1031 exchange, you must do so in the same way you held title in the old property. What the IRS is looking for is the same tax payer(s) on the old, is still the same on the new. If not, you could be jeopardizing the exchange.

For example, let’s say you are the sole taxpayer holding title to a property you would like to do an exchange on. You decide to purchase the new property in a partnership with your son so he can enjoy the property as well. Is this allowed? The answer is no. The tax payer must remain the same throughout the exchange; and in this case, we went from having one tax payer to two separate tax payers. Remember, the IRS is letting you defer taxes on the property, so they will not allow you to just pass the benefit on to someone else, even a close relative.