Do’s and Don’ts of a 1031 Exchange

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The 1031 exchange represents code 1031 of the Internal Revenue Service (IRS) since 1921. Under this code, the exchange of property of a similar kind occurs with the deferment of capital gains or losses.

The provision gives you more time to allow the money gained to work for you. As a result, it is easier to increase the net worth using the 1031 exchange. The conditions for 1031 may be confusing, and that is why you need to pay close attention to the do’s and don’ts.

Do’s

a. Do: Plan for the Exchange

Consult with your attorney, broker and identify a Qualified Intermediary (QI) before investing or exchanging the Delaware Statutory Trust (DST).

b. Do: Find a QI that you Don’t Know.

Suppose you take possession of funds from the sale of your property, and then you will lose the capacity for a 1031 exchange. The QI, a trusted financial institution by the IRS, handles transfers and closing of 1031 exchange proceeds on behalf of clients.

The 1031 exchange basics, according to IRS publication 544, disqualifies any QI you have worked with in the past two years. The idea is to eliminate agents, yet a QI you have experience with acts as an agent. You should ask for recommendations lest your exchange becomes nullified.

c. Do: Exchange Like for Like

The IRS allows the only exchange of like-kind properties in the 1031 exchange. Like-kind property are the properties of the same class, character, and nature exchanged without any tax liability. However, the properties could be of different quality or grade.

It is impossible to swap real estate domestic properties for those that are foreign-based on 1031 exchange basics without tax liabilities. Hence, to enjoy tax deferment, only foreign for foreign or domestic for domestic exchanges are allowed by code 1031.

d. Do: Acquire a Property with Equal or Greater Value

Calculation of the capital gain on the sale of a property is the summation of the purchase price and the capital improvement minus the depreciation. The IRS must capture every depreciation as taxable income from the sale of a property. As a rule of thumb, the acquired property must be more or equal to the property relinquished in value.

Don’ts

a. Do Not Miss Identification and Exchange Deadlines

Once you sell a property, you have a maximum of 45 days to identify a replacement asset. The identification follows three standard guidelines.

i. The three-property rule: You can identify three assets as potential purchases irrespective of the market value.

ii. The 200% rule: You identify an unlimited number of assets so long as the total value does not exceed 200% of property relinquished.

iii. The 95% rule: You identify properties valued at 95% or more of the acquired property.

The exchange is subject to a 180-day time frame. It implies that after 180 days, the assets are considered personal and not part of the 1031 exchange.

b. Do Not Receive Funds for Exchanged Property

The variance in the value of acquired and relinquished properties is called a boot. If a replacement property has a lower value than property sold, the cash boot is taxable.

Property under a mortgage is permissible for exchange. However, if the mortgage for replacement property is less than property sold, the variance is taxable similar to cash boot.

Always ensure that the QI you have selected makes the transactions for you. Otherwise, if you happen to receive the funds from the exchange, the trade ceases to become a 1031 exchange.

c. Do Not Dissolve a Partnership while Doing an Exchange

The same body that relinquishes property must be present in the acquisition of the other property for the 1031 exchange to remain valid. If some of the partners want money instead of property, they risk losing the benefits of 1031.

The exchange remains viable only if the property is exchanged for business, trade, or investments. Otherwise, dissolving a partnership jeopardizes the legality of the sale.

Conclusion

Investors wishing to grow their net worth through real estate then the 1031 exchange presents the best opportunity. However, many complexities need professional advice and assistance. The above do’s and don’ts are among the vital details you need to have before venturing into the 1031 exchange. Seek professional investment advisors to provide you with guidelines for maximum benefits in the 1031 exchange.

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