Before committing to an IRS Section 1031 exchange, it’s important to understand the basics. “1031 exchanges allow you to defer taxes on capital gains from the sale of investment properties if all the proceeds are promptly invested in replacement properties,” explains Ian Bunje, co-owner of Independent Exchange Services, Inc. in San Francisco. “Basically, you’re deferring the taxes until you sell the new property.” To get the most out of a 1031 exchange, it’s best to employ the services of a professional intermediary, but there are still some basic things you should know before making the initial call.
A 1031 exchange isn’t for personal use. The provision is only for investment and business properties, so you can’t swap your primary residence for another home. There are ways you can use a 1031 for swapping vacation homes, but this loophole is much narrower than it used to be. Some exchanges of personal property (like a painting) can qualify, but exchanges of corporate stock or partnership interests can’t.
“Like kind” is a rather broad phrase. Most exchanges must merely be of like kind, which doesn’t mean what most people think it means. You can exchange an apartment building for raw land, a ranch for a strip mall, or even one business for another.
Consider a delayed exchange. Classically, an exchange involves a simple swap of one property for another between two people. But the odds of finding someone with the exact property you want who wants the exact property you have are slim. For that reason, the vast majority of exchanges are delayed, three party or “Starker” exchanges (named for the first tax case that allowed them). In a delayed exchange, you need a middleman who holds the cash after you sell your property and uses it to buy the replacement property for you.
Designate replacement property. Once the sale of your property occurs, the intermediary will receive the cash—you can’t receive the cash or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate replacement property to the intermediary in writing, specifying the property you want to acquire. There’s debate about how many properties you can designate and what conditions you can impose. The IRS says you can designate three properties as the designated replacement property as long as you eventually close on one of them. Alternatively, you can designate more properties if you come within certain valuation tests. For example, you can designate an unlimited number of potential replacement properties as long as the fair market value of the replacement properties doesn’t exceed 200 percent of the aggregate fair market value of all the exchanged properties.
You must close within six months. The 180-day countdown starts right when the sale of your property closes. If you designate replacement property exactly 45 days later, you’ll have 135 days left to close.
If you receive cash, it’s taxed. You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash, also known as “boot,” will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
Consider mortgages and other debt. One of the main ways people get into trouble with 1031 transactions is failing to consider loans or any debt on the replacement property. If you don’t receive cash back but your liability goes down, that too will be treated as your income, just like cash. Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. You have $100,000 of gain that’s also classified as boot, and it’ll be taxed.