1031 Exchanges to Defer Taxes

Sep 20, 2022 By Triston Martin

Real estate brokers, title firms, investors, and even soccer mothers are all likely to have heard of this word, which derives its name from Section 1031 of the Internal Revenue Code (IRC). Before trying to utilise it, real estate investors need to have a solid understanding of the various moving elements that make up IRC Section 1031. An exchange may only be done with properties of the same sort, and the Internal Revenue Service (IRS) laws prevent it from being used for purchasing holiday homes. In addition to this, there are potential complications with taxes as well as time constraints. Here is some information regarding the rules you should be aware of if you are considering a 1031 exchange or are simply interested in them.

The 1031 Exchange

A 1031 exchange, also known as a Starker exchange or a like-kind exchange, is a swap of one investment property for another. This is a broad definition of what a 1031 exchange is. The majority of trades are taxed as sales. Still, if yours satisfies the Internal Revenue Code Section 1031, you will either owe no tax or a significantly reduced amount of tax at the time of the exchange.

In practice, it is possible to alter the structure of your investment without (in the eyes of the Internal Revenue Service) cashing out or recording a gain on your investment. Because of this, the growth of your investment will be postponed from a tax perspective. To be eligible, most trades need to be like-kind, a mysterious word that does not mean what you think it means. It is possible to trade a residential apartment complex for undeveloped property or a ranch for a strip mall. The regulations are very lax in their enforcement. Even trading one company for another is possible, but those who do so carelessly put themselves in danger.

Special Rules for Depreciable Property

Certain regulations must be followed when exchanging property with a declining value. This can result in a profit taxed as ordinary income and refer to as depreciation recapture. In most cases, you may sidestep this recapture by exchanging one building for another of the same structure. On the other hand, if you trade land that has been developed with a building for a property that has not been improved and does not have a building, the depreciation that you have previously claimed on the building will be reclassified as regular income.

Changes to 1031 Rules

Before the Tax Cuts and Jobs Act (TCJA) was passed in December 2017, certain personal property exchanges were eligible for a 1031 exchange. These trades included franchise licences, aeroplanes, and equipment. Only real property, as defined under Section 1031 of the Internal Revenue Code, is eligible at this time.

1031 Exchange Timelines and Rules

Traditionally, an exchange is defined as a straightforward transaction between two parties in which one person trades one piece of property for another. On the other hand, there is a very low chance that you will meet someone with the precise property you want and who also wants the identical property you have.

45-Day Rule

The first issue is selecting a property to serve as a substitute. The cash will be handed over to the middleman after the sale of your home has been finalised. You are not allowed to collect the cash since doing so would invalidate the 1031 exchange.

180-Day Rule

The second time requirement that applies in a delayed exchange pertains to the closure of the transaction. You have a maximum of 180 days after the sale of the previous property to complete the purchase of the new property. Because the two time periods take place at the same time, you must begin counting when the transaction for the sale of your property is finalised. For instance, if you choose a substitute property 45 days later, you will have 135 days remaining to complete the transaction.

Reverse Exchange

You may still be eligible for a 1031 exchange even if you acquire the replacement property before selling the old one, provided you do it in the right order. In this particular scenario, 45 and 180 days are relevant.

Tax Implications: Cash and Debt

After the intermediary has purchased the new home, you could find that you have some cash remaining. In such a case, the third party will transfer the funds to your account after 180 days. This money, which is referred to as boot, will be subject to taxation as a portion of the sales proceeds from the sale of your property, which is often classified as a capital gain.

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