What is a 1031?
A 1031 Exchange is a swap of one business or investment asset for another. Most swaps are taxable as sales, if you come within 1031, you’ll either have no tax or limited tax due to the time of the exchange.
Let’s break it down to simple terms: You can change the form of the investment without cashing out or recognizing a capital gain. This then allows your investment to continue to grow tax deferred. There is no limit to how many times you do a 1031 – you can roll over the gain from one piece of investment real estate to another to another to another and so forth.
You may have a profit on each swap but you’ll avoid a tax until you actually sell for cash many years later.
Here comes the tricky part.
Special rules apply when depreciable property is exchanged in a 1031. It can trigger a gain known as “depreciation recapture” that is taxed as ordinary income. This is avoided if you swap one property for another. But if you exchange improved land with a building for unimproved land without a building, the depreciation you’ve previously claimed on the building will be recaptured as ordinary income.
Make sense? If you’re still not sure – always contact professional help when you’re doing a 1031 Exchange since things can get a little complicated.
10 Things to Know About A 1031 Exchange
1. A 1031 Isn’t for Personal Use – it is only for investment and business property. You can not swap your primary residence for another home.
2. BUT Some Personal Property Does Qualify - Most 1031 Exchanges are of real estate. Some exchanges of personal property can qualify – here is where it is best to contact a professional.
3. ”Like Kind” is Broad - Like really broad. Most exchanges must be of “like-kind”. You can exchange an apartment building for raw land, or a ranch for a strip mall.
4. You Can Do A “Delayed” Exchange – Ideally, an exchange is a simple swap of one property for another between two people. What are the odds of that??! Small. Very Small. And for this reason the majority of exchanges are delayed, three party exchanges. In these delayed exchanged you need a middleman who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you.
5. You Must Designate Replacement Property - There are two key timing components for a delayed exchange. The first relates to the designation of replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can’t receive the cash or it will spoil the 1031. Within 45 days you MUST designate the replacement property in writing to the intermediary specifying which property you want to acquire.
6. You Can Designate Multiple Replacement Properties - The IRS says you can designate three properties as the designated replacement property so long as you eventually close on one of them. You can designate an unlimited number of potential replacement properties as long as the fair market value of the replacement properties does not exceed 200% of the aggregate fair market value of all the exchanged properties.
7. You Must Close Within Six Months – The second timing rule in a delayed exchange relates to closing. You MUST close on the new property within 180 days of the sale of the old. It is important to note that the two time periods run concurrently. Meaning you start counting when the sale of your property closes. If you designate the replacement property 45 days later – you have 135 days left to close.
8. If you Receive Cash – It’s Taxed – Pretty simple. You may have cash left over after the intermediary acquires the replacement property. If this is the case, the intermediary will pay it to you at the end of 180 days. This cash will be taxed as partial sales proceeds from the sale of your property.
9. You Must Consider Mortgages and Other Debt - Here is where most people get into trouble. You MUST consider mortgage loans or other debt on the property you relinquish and any debt on the replacement property. If you didn’t receive cash back but your liability goes down, that too will be considered as income and therefore taxed.
10. Using 1031 Exchange for A Vacation House is Tricky - Yes, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Example: You stop using your beach house, rent it out for six months or a year and then exchange it for other real estate. If you actually get a tenant and conduct yourself in a businesslike way, you’ve probably converted the house to investment property, which should make your 1031 exchange OK. But if you merely hold it out for rent but never actually have tenants, it’s probably not. The facts will be key, as will the timing. The more time that elapses after you convert the property’s use the better. Although there is no absolute standard, anything less than six months of bona fide rental use is probably not enough. A year would be better.
As with any tax related questions – if you’re considering a 1031 Exchange its best to contact your tax professional.
No comments:
Post a Comment