A 1031 exchange takes its name from Section 1031 of the Internal Revenue Code. Basically, it’s a method that savvy property investors can use to defer paying capital gains taxes during the sale of an investment property.
Normally, when selling a property, capital gains taxes can be as high as 30%. But by taking advantage of a 1031 Exchange, you can defer payment of this tax for a technically unlimited period of time.
That said, a successful 1031 Exchange requires strict adherence to Section 1031 of the Internal Revenue Code. If you’re considering using it in the future, here’s everything you need to know.
1031 Exchanges in Nevada
Not all properties can qualify for a 1031 Exchange. Only properties being used for business or investment purposes can qualify. Your personal residence is an example of a property that doesn’t qualify.
Also, a fix-and-flip property won’t qualify. Why? Because a fix-and-flip property fits into the category of properties bought solely for resale.
Other properties that won’t qualify for a 1031 Exchange include:
• Second or vacation homes not held as rental properties.
• Land that is being developed for the sole purpose of being resold.
• Stocks, bonds, notes and partnership interests.
Also, for a 1031 exchange to be successful, it must take the form of an “exchange” rather than just the sale of one property.
In addition, the two properties in the exchange must be “like-kind.”
Basically, like-kind properties have the same nature and character, even if they have varying quality or size.
The following are some examples of properties that would be considered “like-kind” under Code 1031 of the Internal Revenue Code:
- An office in exchange for an apartment building.
- An apartment complex in exchange for a shopping center.
- An industrial building in exchange for a multifamily property.
- A condo for a single-family unit.
Before an amendment was made to the law in 1984, closing and transferring relinquished and replacement property used to be done simultaneously. This was marred with problems, however.
There were difficulties both when trying to find a replacement property and with the simultaneous transfer of titles and funds. This is, however, not the case today!
While such problems are nonexistent today, investors have to follow a strict deadline for a successful transfer.
If you want to carry out an exchange, you’ll first need to list and market your property in the usual manner. Then, after execution of the purchase contract, you must enter a purchase agreement with a qualified intermediary.
Basically, a qualified intermediary is a person who agrees to facilitate a 1031 Exchange by holding funds involved in the transaction. A qualified intermediary can be an attorney, accountant, or real estate agent. You must not be related to them in any way.
A qualified intermediary becomes the substitute seller after entering into an exchange agreement with you.
At this point, the first timing restriction begins. You’ll have 45 days to identify a replacement property after closing and transferring the original one. The 45-day rule isn’t negotiable and includes both weekends and holidays.
If you exceed this timeframe, you run the risk of having the entire exchange disqualified. If that happens, you’ll be liable for payment of capital gains taxes.
You can pick three options when it comes to choosing replacement properties. This is true regardless of their fair market value. You can also go for more properties as long as their aggregate fair market value doesn’t exceed double the value of the relinquished property.
Once you’ve selected a replacement property, you’ll have 180 days to close on the new replacement property. The countdown starts from the day you transferred the relinquished property to when you close on the new one.
According to the Code, you must not touch any proceeds from the sale of your original property. That will be the responsibility of the qualified intermediary who will handle the transfer of funds.
Boot has nothing to do with any type of footwear. In 1031 Exchanges, boot refers to non-like-kind property received in an exchange. It can be in the form of cash, an installment note or debt relief.
Receiving boot may not necessarily halt an exchange. However, it can create a surprisingly large tax liability.
The following is an example of how boot can occur in a 1031 exchange. Suppose you sell a property for $250,000 but only re-invest $200,000. In this case, the difference of $50,000 would become the boot.
The main purpose of doing a 1031 Exchange is to defer payment of capital gains tax. However, receiving boot means the exact opposite. So, the $50,000 would be subject to capital gains tax.
Besides cash proceeds, boot can also be in the form of:
• Mortgage reduction. For example, when debt on the replacement property is less than the debt on the relinquished property.
• Non-transactional costs. Outstanding bills and maintenance are good examples of such costs.
• Personal property. This can also create boot as they aren’t considered real property.
• Property that is not “like-kind”.
The following are some things you can do to avoid boot.
• Ensure any debt on the replacement property is equal to or more than the debt on the relinquished property.
• Reinvest all of the net equity from the sale of the relinquished property when buying a replacement property.
• Buy “like-kind” property with a value similar or greater to the value of the property being relinquished.
There you have it, a full guide on how to carry out a 1031 Exchange. If you’re considering doing it for the first time, hiring a professional can be the best option for you.
Evolve Nevada is a trusted property management company in Reno. We have the expertise to help you find the best replacement property for a successful exchange. Please contact your financial advisor or CPA for tax implications specific to your situation.