Selling business or investment property generally requires that the seller/taxpayer pay capital gains tax. However, if the taxpayer complies with the IRS rules for 1031 exchanges (also sometimes referred to as “like-kind” or “Starker” exchanges), they can reinvest the proceeds from the sale of the relinquished property into a newly acquired property. Tax on the gain that was reinvested will be deferred until they sell the newly acquired property.
In this article, we explain what 1031 exchanges are, including:
- How does a 1031 Exchange work?
- What is Boot and how does it work?
- What type of properties qualify?
- The importance of an exchange agreement and qualified intermediary
- What about property I want to use, like vacation homes or property for my family?
How does a 1031 exchange work?
Perhaps the most important elements that differentiate a 1031 exchange from a regular sale of property are 1) an Exchange Agreement and 2) a Qualified Intermediary. By the time the taxpayer is ready to close on the relinquished property, there must be an Exchange Agreement in place that identifies the taxpayer’s property being relinquished, and who the Qualified Intermediary is that will take possession of the property/proceeds in order to purchase the replacement property that the taxpayer wishes to acquire. The intermediary is necessary because if at any time the taxpayer or other disqualified person comes into possession of the proceeds, the deal can no longer be considered an exchange and will be taxable capital gain.
Once the relinquished property has been properly closed with an exchange agreement and intermediary in place, the taxpayer has 45 days from the date of closing to identify potential replacement properties. The taxpayer has 180 days from the date of closing to acquire the replacement property. The 180 days IS NOT added to the 45 days, they run concurrently.
Assuming all provisions of the tax code are followed, the intermediary can use the proceeds of the relinquished property to purchase and close on the replacement property, disburse the replacement property and any additional funds to the taxpayer, and the taxpayer will have enjoyed deferred capital gains tax on the property that was exchanged. (Some portion of the exchange may still be taxable, that will be discussed below).
A reverse exchange is also possible, though a little more complicated. A reverse exchange can be used when, for whatever reason, a taxpayer wants to acquire a replacement property BEFORE selling a like-kind (relinquished) property. For a reverse exchange to benefit from deferred taxes, the purchase of the replacement property must be done through an intermediary known as an exchange accommodation title holder, this intermediary will likely have an accommodation agreement with the taxpayer, and more obligations than an intermediary in a standard 1031 exchange.
Once the replacement property has been purchased and is in the possession of intermediary, it can remain “parked” in the possession of the intermediary for up to 180 days while the taxpayer disposes of relinquished property in order to complete the exchange.
What is Boot and how does it work?
“Boot” is Non-qualifying property included as part of the exchange, such as cash, tainted property, or decreased debt. Any net proceeds that the taxpayer keeps after the exchange, along with any other boot, will be taxable. To maximize the deferral and defer all proceeds from the relinquished property the taxpayer must select a replacement property or properties that have greater or equal value and debt than the relinquished property.
If the relinquished property has more debt than the acquired property, the net difference in debt will be added to the taxable boot. For an example, see the illustration below.
What type of property qualifies?
Almost all real property within the United States is fair game (though improvements without land cannot be exchanged for real property with land). Both relinquished and replacement properties must be business or investment property and held for that purpose.
What about property I want to use, like vacation homes or property for my family?
The short answer is do not do it. Mixing personal use with business in this situation is a good way to get flagged by the IRS, and nobody wants that. However, as long as you can show sufficient rental income, your personal use of the property in each of the two 12-month periods before and after the exchange can be 14 days or 10% of the time in that 12-month period that the property was rented at fair market value.
Keep in mind that personal use includes use by the owner, family members, other people with an interest in the property or their families, anyone using the unit that is allowing the taxpayer to use some other dwelling unit, or ANYONE if the property is rented for less than fair market value rent.
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