Demystifying 1031 Exchanges

1031 exchanges have enjoyed explosive growth in popularity in recent years. Once the sole domain of professional investors and commercial brokers, today you will find 1031 exchanges being used by professional and casual investors alike.

However, along with this popularity has come many misconceptions about this powerful tax-deferral tool. Allow us to debunk some of the most common myths about 1031 exchanges.

A taxpayer cannot complete a 1031 exchange with a related party.

FALSE! Related parties can buy or sell property in a valid 1031 exchange. When related parties (e.g., parents, spouses, children, siblings, etc.) exchange property, the related party is obligated to own the property for at least two years following the exchange before selling or exchanging it again. Failing to adhere to the Two-Year Rule will render the 1031 exchange invalid.

All tax liability is always deferred in a 1031 exchange.

FALSE! Boot is an important concept to understand in 1031 exchanges. Boot is any cash not spent on the purchase of replacement property. Boot is fully taxable regardless of the investor’s adjusted basis on the property. Boot is subject to federal capital gains tax of 15%, as well as any state capital gains tax that may apply. Likewise, if the property was depreciated after 1997, boot may be also subject to a 25% recapture tax.

The 180-Day rule can be extended.

FALSE! The IRS is very strict when it comes to enforcing the time limitations imposed on 1031 exchanges. Like-kind exchanges must be completed within 180 days after the deed transfer date of the relinquished property (or the replacement property in the case of a reverse exchange). This means if the 180th day falls on a Saturday, Sunday or holiday, closing must occur on or before that date – waiting until the next business day will cause the exchange to fail.

Vacant land does not qualify for a 1031 exchange.

FALSE! Any property that qualifies as real estate (as defined individually by each state) qualifies for a 1031 exchange. This means that things like water rights, mineral rights, leasehold interests greater than 30 years, and even air rights are eligible for an exchange. Of course, since each state defines “real estate” differently, it always pays to first confirm that an asset is eligible ahead of time.

Anyone can act as the qualified intermediary.

FALSE! The IRS sets forth limitations on who can function as a qualified intermediary (QI) – the entity that will hold funds and title to exchanged property during the exchange. Neither the investor’s attorney or CPA can perform the QI role if they provided services to the investor within the preceding two years. Also, any real estate agent representing any party in the exchange is also prohibited from serving as the QI.

Residential property can never be for personal use.

FALSE! As long as an investor follows certain guidelines, properties like second homes or vacation homes can qualify for a 1031 exchange and be personally used by the investor. An investor must offer the property for rent at fair market rate and can then use the property him or herself for up to 14 days per year or 10% of the time the property is rented – whichever is greater.

To find out how we can help you find and close on your next 1031 exchange property or to learn more about the exchange process and our qualified intermediary services, please visit our website.