Many astute investors are familiar with the primary requirements of a successful 1031 exchange, which, when executed correctly, allows for the deferral of significant capital gains taxes on the sale of an investment property. However, delving deeper into the process reveals many subtleties that are often overlooked. Here are some crucial finer points to consider.
Common Knowledge About (Forward) 1031 Exchanges
- Your replacement property must be of equal or greater value than the one you are selling (the relinquished property).
- You need to use a Qualified Intermediary (QI) to perform the exchange. The QI needs to be a trustworthy entity/person, as they will hold your funds in their name while the transaction is completed. The proceeds from your sale must be held in escrow by the QI. If you handle the funds yourself, even briefly, you will lose all the tax benefits.
- You have a 45-day window from the time you close on the relinquished property to identify a replacement property.
- You must finalize the purchase of the replacement property within 180 days of the closing date of the relinquished property.
Delving Deeper: Lesser-Known Facts
You Can Also Do a “Reverse” 1031 Exchange
- Reverse 1031 exchanges are normally more expensive than forward 1031s.
- If you (the taxpayer) buy the replacement property first, you can do a reverse 1031 exchange. You still need to set this up with the QI in advance, at least 2 weeks before the closing. Title for the replacement property will be held in the name of an LLC (the Exchange Accommodation Titleholder or EAT). At the end of the transaction the property will be deeded to you.
- The same 45-day identification period and 180-day exchange period deadlines apply.
Incorporate Your Mortgage into the Sale Price
- Many taxpayers overlook this detail: if you’re selling a property for $500,000 but still owe $200,000 on your mortgage, you need to exchange it for a property worth at least $500,000. This often means securing a new mortgage of at least $200,000 on the new property!
Watch Out for the “Boot”
- If you sell your relinquished property for $500,000 and purchase the replacement property for $400,000, the $100,000 difference is known as the "boot", which is subject to capital gains tax. You can avoid this by ensuring the replacement property is of equal or greater value than the relinquished one.
Your Replacement Property Must Be in the U.S.
- Unfortunately, you can’t use a 1031 exchange to buy that dream beachfront property you wanted in Costa Rica.
You Can Purchase Multiple Replacement Properties
- You’re allowed to identify up to three replacement properties within 45 days of selling your relinquished property. However, there are exceptions:
- You can identify more than three replacement properties, as long as their total value does not exceed 200% of the sale price of your relinquished property.
- You can list as many replacement properties as you want, as long as you ultimately acquire at least 95% of their total value.
- Your QI will assist in properly documenting your target properties.
Deferred Capital Gains Taxes Disappear Upon Death
- While capital gains taxes are technically deferred, they are waived upon death. Your heirs inherit the property without the burden of paying deferred capital gains taxes.
Final Thoughts
In summary, the 1031 Exchange remains a powerful tool for preserving your equity and deferring taxes. However, it is crucial to thoroughly understand all regulations and loopholes. One misstep can negate all your tax benefits!
Please consult with your CPA and/or tax attorney before you execute a 1031 Exchange.
Sources: Biggerpockets.com, IPX 1031
