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1031 Exchange Rules: A Guide for Investors

Oct 03, 2023

Knowing the mechanics of 1031 exchange rules for tax-deferred exchanges can massively impact your investments in the long run. Under Section 1031 of the Internal Revenue Code, you can swap one real estate investment for another and defer capital gains taxes. However, navigating the rules of 1031 exchanges, such as like-kind properties and time frames, is easier said than done. 

What is Section 1031?

Section 1031, or the like-kind exchange, is an advantageous provision in the Internal Revenue Code for investors. It allows an investor to swap one investment property for another, potentially without tax due at the exchange time. This action supports the growth of your investment tax-deferred, meaning you can profit from each swap without paying tax until you decide to sell for cash. The term “like-kind” provides more flexibility than it seems, as you could theoretically exchange properties as diverse as an apartment building for raw land. There is no limit on the frequency of 1031 exchanges, although the rules apply mostly to investment and business property, with some exceptions. Both properties in the exchange must be within the U.S. to qualify.

Special Rules for Depreciable Property

Depreciable properties entail specific rules in a 1031 exchange. Exchanges of these properties could lead to depreciation recapture, taxed as ordinary income. For instance, if you trade a depreciated building for unimproved land, previously claimed depreciation becomes average income. The intricacies surrounding depreciable properties can lead to tax pitfalls if not handled correctly, pushing the need for expert guidance in a 1031 tax-deferred exchange transaction

Changes to 1031 Rules

The 1031 exchange rules were changed under the Tax Cuts and Jobs Act (TCJA) in 2017. Previously, a broad range of properties, including those unrelated to real estate, met the 1031 exchange rules criteria. However, the TCJA has now limited these exchanges strictly to real estate transactions. This significant change means personal properties like artwork, cars, and other collectibles no longer qualify for a 1031 exchange. Staying updated with these changes is integral for investors to make the most of their 1031 tax-deferred exchange transactions.

1031 Exchange Timelines and Rules

The timelines and 1031 exchange rules are strict and must be followed. A notable type of 1031 exchange is the Delayed, Three-party, or Starker exchange. This involves an intermediary who holds the cash after the property is sold and uses it to buy the replacement property for the investor.

Key timing rules to remember are the 45-Day Rule, where the investor must identify the replacement property within 45 days from the date of sale of the relinquished property, and the 180-Day Rule, in which the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property. Lastly, the concept of a Reverse Exchange allows investors to acquire a new property before identifying the old property to be sold within a given timeframe.

Tax Implications: Cash and Debt

The concept of ‘Boot’ comes into play for 1031 exchange tax implications. For instance, if you receive anything other than like-kind property during your exchange, it is termed as ‘Boot.’ This could be in the form of cash, debt relief, or even services. And here’s the catch—the ‘Boot’ is taxable. 

Likewise, loans are just as important when performing a 1031 exchange. If the loan on the replacement property is less than the loan on the relinquished property, the difference is considered ‘Boot’ and is taxable. So, the key takeaway here is to ensure your loans are structured correctly in a 1031 tax-deferred exchange transaction to avoid any unwanted tax implications.

1031 Exchanges for Vacation Homes

Previously, a loophole in the 1031 exchange rules allowed investors to swap vacation homes tax-free, but changes in the law have tightened this area. To qualify a vacation home for a 1031 exchange, it must strictly adhere to ‘qualified use’ standards. Simply put, you must rent out the property at fair market value for at least 14 days per year. Also, your own use of the property should not exceed 14 days or 10% of the total days you rent it out—whichever is greater. 

Moving Into a 1031 Swap Residence

Moving into a property obtained through a 1031 exchange involves certain stipulations. The Internal Revenue Service (IRS) demands a “safe harbor” period of at least two years, where the new property must be rented out before you can move in. Failure to comply with this requirement can lead to transaction disqualification as a 1031 exchange by the IRS. Once you move in, the property becomes your primary residence and is subject to different tax rules. 

1031 Exchanges for Estate Planning

It’s a common misconception that 1031 exchanges come with an inevitable, hefty tax bill due to deferred taxes—but there’s a way to circumvent this. If the investor passes away before selling the property acquired through a 1031 exchange, the deferred taxes disappear, leaving no tax burden for the heirs. As a result, the heirs inherit the property at its adjusted market value. This feature of 1031 exchanges makes it an effective tool in estate planning.

Reporting 1031 Exchanges to the IRS

When it comes to reporting a 1031 exchange to the IRS, precision and accuracy are crucial. The IRS Form 8824, “Like-Kind Exchanges,” is used to report the exchange and calculate the deferred gain. This form is filed with your tax return for the year of the exchange. Any misreporting can lead to complications and penalties. While NexGen provides closing services and issues title insurance for exchange transactions following specific instructions from 1031 exchange specialists, we do not facilitate these transactions ourselves. We routinely refer these exchanges to Towne 1031 Exchange, LLC, a subsidiary of TowneBank that specializes in these transactions.

We recommend that customers engaging in a 1031 exchange consider our partners at Towne1031. Teaming with them, we can provide our usual title and settlement services, offering you a seamless, team-oriented solution for your tax-deferred transaction. For a perfectly coordinated transaction, contact us today.

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