For 2019, here are our latest top 10 misconceptions we’ve found that the public has about 1031 Exchanges:
1. “Like-kind” means I must exchange the same type of property, such as an apartment building, for another apartment building.
The term “like-kind” refers to the nature or character of the property not its grade or quality. For this reason nearly all real property is like-kind to each other.
What is qualified like-kind property?
2. A 1031 Exchange means that the sale and the purchase have to happen at the same time. In other words, the seller has to find someone willing to swap properties.
The odds of that you will find someone who wants to swap properties are slim. For that reason the vast majority of exchanges are “delayed exchanges” which allows you to sell your property and then purchase any new investment property you desire providing the 1031 like kind rules are followed. Probably the most important rule is that taxpayers must hire a 1031 intermediary prior to transferring their old property.
What is a tax-deferred exchange?
3. My attorney or CPA can handle the exchange for me as my Qualified Intermediary.
If the seller’s attorney or accountant has provided any legal or accounting related services (or any service not exchange-related) in the two-year period before the exchange, they are disqualified and may not act as the Qualified Intermediary. Your use of them to facilitate an exchange will disqualify your transaction because they are considered your agent.
The role of the qualified intermediary
4. To do a 1031 Exchange I just need to file a form with the IRS with my tax return and “roll over” the proceeds into a new investment.
A valid exchange requires much more than just reporting the transaction on Form 8824. One of the biggest missteps when structuring an exchange is allowing the taxpayer to have actual or constructive receipt of their sale proceeds. This triggers a taxable event. An independent third party (a Qualified Intermediary) must hold the sale proceeds during the course of the exchange. There are also specific 1031 Exchange regulations and deadlines that must be adhered to as well.
How to plan ahead for a successful exchange
1031 deadlines and identification requirements
The exchange process
5. I can only defer my capital gains tax via a 1031 Exchange.
Besides capital gains taxes, you can also defer the depreciation recapture tax, the Net Investment Income tax and State taxes (if applicable). Therefore, if you do not exchange and elect to pay taxes, you may have an effective or blended capital gains rate as high as 35% to 40%
Boot in 1031 Exchanges
How to avoid boot
6. All of the funds from the sale of the relinquished property must be reinvested.
A taxpayer or exchanger can buy down in value. Or a taxpayer can choose to withhold funds or receive other non-like-kind property in an exchange. But the amount that they buy down, or money they withhold, or any other non-like-kind property received, is considered “boot” which means the exchanger likely will have to pay some taxes.
See different amounts you can defer with our Capital Gains Estimator
7. You must replace the debt that you had on the relinquished property with at least the same amount of debt on the replacement property.
The exchanger can always bring their own cash (from outside of the 1031 Exchange) to the closing table for the replacement property to offset any reduction in debt. You need to replace the value of the debt paid off on the relinquished property.
Replacing debt in a 1031 Exchange
8. Opportunity Zone Funds are another alternative to defer my taxes.
But remember that the tax deferral on your capital gains invested in these funds will expire at the end of 2026. Then it will be time to pay the IRS. With a 1031 Exchange you can defer paying taxes on those gains until your death as well as providing your heirs with a “stepped up basis” in the inherited property in addition to other tax benefits not available with investments in Opportunity Zone Funds.
Opportunity Zones – a good investment?
9. When I sell my personal residence I need to set it up as a 1031 Exchange.
Tax-deferred exchanges cannot be used for real property held only for personal use. The good news is that Section 121 of the tax code that allows you to sell your home and avoid capital gain tax up to a certain amount. If you own an apartment building and are using one of the units as your personal residence, you may need to utilize Sections 1031 and 121 for maximum tax deferral/savings by applying the guidance provided by Revenue Procedure 2008-16.
How to convert your principal residence to minimize taxes by combining IRC §1031 and §121
10. If I sell property I can only exchange into one property.
Per 1031 Exchange rules, you can sell one property and exchange into multiple replacement properties. In addition, you can sell multiple properties and exchange into one larger and more easily managed property.