A 1031 exchange is an arrangement that allows business owners to purchase and interchange property to make investment gains while paying limited tax or no tax at all. Investors may exchange any like-kind property, or “property of the same nature, character, and class,” as explained by the Internal Revenue Service (IRS). This regulation grants businesses the ability to transform the investment asset, thus gaining capital without having to pay taxes until a property is ultimately sold for cash. Here are seven important things to know about 1031 exchanges to gain an in-depth knowledge and maximize business advancement.
1031 exchanges are not for personal use or personal property.
This section of the IRS tax code is designed specifically for real investment property. This means the real estate or property must be structurally permanent and used in a productive manner for business, trade or investment purposes. To qualify for a 1031 exchange, the properties involved cannot be primary residences, secondary residences or any other form of personal property such as furniture or equipment.
1031 exchanges do not have to be instantaneous.
A delayed 1031 exchange is a standard option to postpone the transaction. In a delayed 1031 exchange, a qualified intermediary retains the proceeds until a replacement property is selected to be acquired. Following the sale date, the intermediary will accept and secure the sale revenue, and the initial investor has 45 days to identify a replacement property. Once a replacement property is chosen, the intermediary transfers the revenue to the replacement’s seller, and the investors must finalize the purchase within 180 total days from the original sale date.
Choosing a replacement property has options and parameters.
In a delayed 1031 exchange, an investor must adhere to the parameters and restrictions when choosing a replacement property. One option allows the investor to identify up to three potential replacement properties. Another option permits the investor to identify an unlimited number of replacement properties if the combined value does not exceed 200 percent of the value of the original property. A third and final option involves identifying an unlimited number of replacement properties regardless of value if the investor acquires at least 95 percent of the selected properties.
Leftover “boot” or cash is taxed.
Occasionally, an investor may receive cash as part of the 1031 exchange. This occurs when one of the properties is of lesser value than the other. As a result, money that is leftover in an exchange is known as “boot” and taxed as regular income or capital gain. Avoiding boot is ideal if the investors wish to keep the exchange tax-free.
Mortgage and loan differentials are also taxed.
Mortgage loans and other forms of debt on both the relinquished and the replacement property must be considered during a 1031 exchange. When acquiring the loan on a new property, any capital gains are subject to taxes and treated as boot. For example, if real estate with a remaining $500,000 loan balance is exchanged for real estate with a $450,000 loan balance, the capital gain of $50,000 is deemed income and taxed as such.
The use of funds acquired from a 1031 exchange is regulated.
A 1031 exchange involves fees and expenses that influence the value of the transaction or leftover boot. To remain compliant with 1031 regulations, an investor cannot use funds to cover insurance premiums, taxes on the property, security deposits, credit card balances, property maintenance expenses or financing fees. Permissible selling expenses include escrow fees, recording or filing fees, attorney fees related to the exchange, tax advisor fees also related to the exchange, finder and referral fees, real estate broker commissions and qualified intermediary fees.
Like-kind in a 1031 exchange is a broad concept.
The IRS’s interpretation of like-kind property in a 1031 exchange is liberal. Like-kind refers to the property’s nature and character as opposed to its quality. Any real property can be exchanged for several different types of other real property. If the property is of similar value and is solely retained for investment and business purposes, an investor could exchange a vacant lot for a restaurant, or an office building for an apartment building. The list of qualifications for like-kind is broad.
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