A 1031 exchange is a tax strategy used by real estate investors to defer capital gains taxes on sale proceeds of investment properties. The IRS’s rules for 1031 exchanges are complex, so it is important to work with a tax professional who has experience in real estate taxes and can help you navigate the process.
Like-Kind Property
The IRS considers a property to be eligible for a 1031 exchange only if the property is held as an investment and has a “like-kind” replacement. Generally, this means the property being sold must be of equal or greater value to the property being purchased. If the replacement property is not of like-kind, the IRS can deem the transaction non-compliant and assess capital gain tax.
One common mistake that can be made in a 1031 exchange is to sell a property with a higher price than the replacement property. The seller will then have to pay tax on the difference between the sale price and the purchase price of the replacement property, which can be a substantial amount.
Another common mistake is to transfer equity out of the relinquished property before the replacement property is received. This may be done by selling a note, which is essentially a debt that represents equity in the property being sold. The Exchangor can either sell the note or use the cash in the acquisition of the replacement property to buy a new note, which is then paid off and completes the exchange.
A 1031 exchange is a time-consuming process that requires a lot of planning. Investors must identify their replacement property within 45 days of the original property’s sale date and close on the replacement property within 180 days of the original sale date. If any of these deadlines are missed, the investor will have to pay capital gains taxes on the first transaction.
Delayed Exchanges
While it is true that the IRS has approved delayed exchanges, this type of transaction has a number of potential complications. For starters, it may not be possible to identify the replacement property during the 45-day window. Fortunately, experienced real estate investors know that the best time to find a replacement property is before a property has been sold.
This is because the replacement property must be a like-kind replacement and not a non-like-kind replacement. That is why many experienced real estate investors avoid delayed exchanges as much as possible.
Boot
The old English term boot, which means “something that is given in addition to,” refers to money or the fair market value of an additional item that is received during a 1031 exchange. Boot can result from excess cash proceeds, mortgage reductions, and other factors.
Depreciation Recapture
Depreciation recapture is an important consideration for any real estate investor who is considering a 1031 exchange. This is because it can reduce the tax benefits of a 1031 exchange and even wipe out some of the depreciation that the investor has already taken.
