A 1031 exchange is not for everyone. The question is often asked “Should I do a 1031 exchange?” It depends. What are the tax consequences of the sale? Do you want to own replacement property? Are your long term goals appreciation, cash flow or possibly converting the rental property into your primary residence?
1031 Exchange Misconceptions
Tax Free
1031 exchanges are loaded with rules created by the United States Treasury Department Regulations and enforced by the Internal Revenue Service. It is easy to get confused, but let’s be clear, a 1031 exchange does not mean “tax free.” The tax obligation triggered is deferred, no payment is required when filing your federal tax return given the property sold was held in a business or investment is replaced with property held in a business or investment in a 1031 exchange. This means that the tax that would have been due upon sale is postponed, payment deferred until the replacement property is sold. If a 1031 exchange is initiated prior to the closing or escrow, then the gain is deferred for a second time or indefinitely until the replacement property is sold and conveyed at closing or escrow.
Personal Use
Real and personal property held in the productive use of a business or for investment whether in the United States or internationally is eligible for state and federal capital gain and depreciation recapture tax deferral. Any real property can be exchanged for any real property while personal property must be replaced or exchanged with like-kind personal property from the same general asset or product group class. Property held primarily for personal use, such as a primary residence, second home or vacation property with personal or related family member use that exceeds fourteen overnights per year, is not eligible for 1031 consideration. Real property in the US is considered like-kind with property in the US while property overseas is considered like-kind with property held internationally.
Indebtedness
Can the taxpayer defer the gain in a 1031 exchange by using the net sales proceeds to pay down debt on another investment property or a primary residence? No, because debt is not real, tangible or intangible personal property. Related Party
A related party is anyone of ascending or descending blood lines, including grandparent, parent, siblings, children and grandchildren, or if you own 51 percent of an entity. There are related party rules that apply to prevent basis shifting.
Accommodator
The 1031 exchange must be facilitated by a qualified intermediary (QI) who is not considered a disqualified person or someone or firm that has acted on your behalf within two years of the intended property closing. If the buyer wants the seller’s property and the seller wants the buyer’s property, also known as a two party exchange, a QI is not required. Attorneys who have provided real estate closing services can be the QI. Banks may act as the QI.
1031 exchange must be set up prior to the closing or escrow. If the taxpayer has access to the exchange funds (earnest money deposit is fine) as in a check held in escrow, the g(6) limitations of constructive receipt have been violated and a 1031 exchange is not possible. One of the primary reasons for the QI is to hold the exchange proceeds in an escrow account under your tax identification number as the fiduciary or guardian of the 1031 exchange funds.
Seek CPA Input
Talk with your CPA to determine whether or not the sale triggers a tax. If so, do you want to own another property? If the answer is yes to both questions, then talk with a QI to understand how a 1031 exchange works for your specific transaction.
Inventory, indebtedness, stocks and securities, partnership interests and primary residences are not eligible for 1031s.
If you have a question, click on the button below for a quick and thorough response from a Certified Exchange Specialist®.
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