There are countless myths and misconceptions about 1031 exchanges. What follows are a few of the myths heard over and over again in our offices. Here we attempt to set the record straight.
Myth #1 – To do an exchange you have to buy equal or up! – False
Or, sometimes Taxpayers think they have to buy for a dollar more than they sold. Believing these myths, Taxpayers have done things they didn’t want to do. For example, they overpay for the replacement property believing that if they sell for $362k they must buy for $362k even if the replacement property is worth something less. Or, they pay taxes thinking they cannot even do an exchange because they sold for $362k and their replacement property is only worth $325k.
In truth, if the sale is at $362k their target is never $362k. It is $362k net of closing costs. If closing costs are $22k then their target is $340k. If the perfect replacement property is worth $325k they just pay tax to the extent they fall short of the target. (The accounting has been simplified for illustrative purposes but the principle remains.)
Myth #2 – 1031 is only for commercial properties. – Again, False!
1031 is for properties held for investment or for productive use in a trade or business. This certainly includes commercial properties but it also extends to rentals and to land held for investment. While a high percentage of commercial transactions have 1031 as a component the vast majority of investment properties are residential rentals – single family and duplex properties. Just as with commercial properties, when selling an appreciated rental or investment land the Seller should consult with their tax advisor to determine whether a 1031 would be beneficial.
Myth #3 – If you are doing an exchange and selling a rental you have to buy a rental! – Yet again, False!
Another myth that will not die. Believing this myth the Taxpayer, fed up with tenants, will pay their tax and get out of real estate!
Perhaps the second best feature of a 1031 (the best feature being the tax deferral) is the generous definition of what it means to be “like kind” real estate. All real estate is like kind as long as what is being sold is held for investment or for productive use in a trade or business and what is being purchased will be held for investment or for productive use in a trade or business. In other words, the Taxpayer can sell a rental and buy a commercial building – like kind! The Taxpayer can sell a commercial building and buy multiple bank-owned single family houses as rentals – like kind! The Taxpayer can sell land and buy a building to house their business – like kind! The combinations are truly limitless.
NOTE – some information has changed with current laws. Please see Top 1031 Misconceptions for 2019 here.