How Do 1031 Exchanges Work – Part I

Two of my investor friends told me they were going to ask me about 1031 exchanges. Rather than give them the same spiel, its just easier I wrote my own opinions here so I never have to repeat myself! Since its a long topic I’ll break it down into a few different posts.

What is a 1031 exchange?
Its a means by which you can sell or exchange property and defer paying taxes. Deferring your taxes is a good thing. It allows you to grow you money at a faster rate.

What sort of property qualifies for a 1031?
Any property held as an investment is eligible. Most CPAs will tell you that you need to demonstrate an intent to hold the property as an investment and ideally you want to hold it for atleast 12 months.[some even say 18 months]. Short term flips do not qualify. Apparently the IRS doesn’t equate speculation with investment.

What can I exchange my property for?
You can exchange your property for like-kind property. If you own property you can exchange it for any other kind of property and oil royalties too. However livestock and vehicles are covered under this rule too and you can’t exchange your cows for an airplane or a tractor for land. However within the scope of real estate, land for apartment buildings, SFHs for oil wells and even lease-hold property for fee-simple property is allowed. A lot of investors are cashing out there investments and are investing in tenants-in-common commercial buildings. They 1031 into larger investments with a bunch of other investors and get a fixed rate of return[usually 6-11%]. They essentially exchange management headaches for a fixed rate of return.[More info on that in another post].

What are the steps involved in setting up a 1031 exchange?

  • You need a qualified intermidary, also called an accomodator. You must not receive any money from the sale of the property. It has to be held by the accomodator. He takes possession of the proceeds from the sale of your property, uses the funds to purchase the new property, then transfers title of the property to you.
  • You have 45 days from close of escrow to identify the replacement property. You should start looking much earlier than that but you need to give written proof to your accomodator of your selections.
  • Close on the purchases within 180 days from the sale of the original property, or before you file your tax return. If you sell you original property on December 31st, you have until April 15th to close on the replacement, unless you file an extension.

It gets a lot more complicated than these simple steps. There are rules for mortgage amounts and total property amounts, partial exchanges and taxes owed on boot[the amount that you’ve withdrawn].

One of the funny things is that any equity you put down during the original purchase of the house is locked into the exchange. If you pull that out during the exchange it will be considered boot and you will have to pay tax on that money. One way to get around this is to refinance the house a year before you plan on doing a 1031 and pulling your equity out. Alternatively, you could complete your exchange and then refinance the property to pull your equity out.

Its getting late, more on 1031 exchanges later.

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