In a 1031 exchange an investor trades one business or investment asset for another asset. If fully complied with, Section 1031 allows the parties to treat the trade as a non-recognition transaction that defers any capital gains taxes. Changing the form of your investment without recognizing a capital gain allows compounded growth of your investment--your investment continues to generate earnings undiminished but it also carries an undiminished potential liability for capital gains taxes. There are traps for the unwary, and it seems to us that you will need professional legal help to conduct a Section 1031 exchange. If you are learning the basics about Section 1031 exchanges, you will want to know all of these basic facts about 1031 exchanges. Some of these facts may be surprising to you.
1. Trades or exchanges are by default treated as fully taxable but for Section 1031 or another rule, if any, with a similar effect.Although, under Section 1031, subject to its many limitations and caveats, no taxes become due at the time of the 1031 exchange (or only specific taxes), non-compliance with Section 1031 means an exchange is treated by default as fully-taxable as to all of the parties, unless some other basis, if any, for non-recognition treatment happens to be available.
2. A 1031 isn’t for personal use property (like a personal residence) or securities (like stocks).
You can’t swap your primary residence for another home under Section 1031, which is only for investment and business property. Nonetheless, there are ways you can use Section 1031 for former or future vacation homes, but this loophole involves some unique limitations and requirements. Also exchanges of corporate stock or partnership interests don’t qualify under Section 1031.
3. But Section 1031 is not only for real estate.
Most 1031 exchanges are of real estate. However, some personal property (eg., equipment, furniture) can sometimes qualify for 1031 exchange treatment. You can even exchange, under some circumstances, one business for another.
4. “Like-kind” is used in its broadest-possible sense in the context of Section 1031 exchanges.
Section 1031 exchanges are also required to be "like-kind" exchanges. But the phrase like-kind does not refer to a kind of real estate, it refers to a kind of property generally, and in this broader context, real estate itself is one kind of property. Most exchanges must merely be of a “like-kind” in this broad sense, and, therefore, any kind of real estate can be traded for any other kind. Both properties are "like kind" because both properties are real estate. Therefore, you can exchange raw land for an apartment building (not merely for other raw land), or exchange a hotel for a cattle ranch or a strip mall. A tenant in common interest in real estate does qualify as "like-kind" real estate under Section 1031.
5. Three-party delayed exchanges are the norm and while an 1031 exchange can be made in one step between two parties, rarely happens in the real world.
In a prototypical exchange, two people are exchanging one thing for another at one closing. Section 1031 is currently interpreted to allow a three-party delayed exchange. As a practical matter it would be truly remarkable when one person finds their "present property's future buyer" and their "future property's present owner" to be actually one and the same person. A 1031 exchange rarely has been conducted in the prototypical way following the judicial recognition of a deferred exchange under Section 1031. However, particular conditions and rules apply. Those special conditions for deferred exchanges raise the following, and other, additional serious considerations.
A. You must designate replacement property according to the 45-day timeline.
This is the first one of two key timing issues that occur after the sale of your own property. A delayed exchange requires the designation in writing of replacement property within 45 days after (or before) the sale of your original property.
B. You can designate multiple replacement properties.
There’s long been debate about how many properties you can designate and what conditions you can impose. The IRS says you can designate three properties as the designated replacement property so long as you eventually close on one of them. Alternatively, you can designate more properties if you come within certain valuation tests. For example, 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.
C. You must close a purchase of identified replacement property within six months.
The other timing rule in a delayed exchange relates to closing the purchase of replacement property. You must close on the purchase of a replacement property within 180 days after the closing of the sale of the original property.
D. If you receive any sale proceeds for even an instant, that very cash will be taxed.
You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash–known as “boot”–will be taxed as partial sales proceeds from the sale of your property.
E. You need a middleman to hold the sale proceeds.
In order to qualify a delayed exchange for the treatment accorded by Section 1031 to a direct one-for-one exchange, you need the cash proceeds of the sale of your property to be held by an independent qualified intermediary/middleman who uses those particular funds to purchase your replacement property, entirely on your behalf and for your benefit of course. Therefore, the intermediary will receive the cash from your sale escrow and retain all of it until paying for the replacement property with it, and then afterward can make a taxable cash payment to you if you desire one.
6.You must consider mortgages and other debt.
You must consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property. If you don’t receive cash back but your liability goes down, that too will be treated as income to you just like cash. Suppose you had a mortgage of $150,000 on the old property, but there is no mortgage on the property you receive in the exchange. You have $150,000 of gain that will be classified as “boot,” and it will be taxed. People get into trouble with these transactions by failing to consider loans.
7. There’s no limit on how many times or how frequently you can do a 1031.
You can roll over the gain from one piece of investment real estate to another to another and another. Although you may have a profit on each swap, you avoid tax until you actually sell for cash many years later. Then you’ll hopefully pay only one tax, and that at a long-term capital gain rate.
8. Special rules apply when depreciable property is exchanged in a 1031.
Depreciated property can trigger gain known as “depreciation recapture” that is taxed as ordinary income, not capital gains. In general, if you swap one building for another building, or one machine for another machine, you can avoid this recapture. 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.