U.S. Internal Revenue Code Section 1031 allows real estate investors to swap one property for another and defer recognizing some or all the gain and the related tax liability from the sale of the first property—assuming some very specific rules are met. Over the years, the IRS-prescribed process has become increasingly more strict. While it previously included the exchange of various types of “like-kind” assets, such as cars or boats, it now only applies to real estate assets held for investment or used in a trade or business.
In this blog article, I will sift through some of the most essential components of these rules, most importantly, the receipt of cash or non-like property. Additionally, it is crucial to pay attention to the ever-changing U.S. tax law regarding 1031 exchanges.
1031 Exchange Deadlines and Other Requirements
It is very important to note that all 1031 exchange transactions are deadline-driven. To take advantage of this tax deferral opportunity, you must identify a new (exchange) property to purchase within 45 days of a property sale. Then, you have 180 days from the sale to close on that exchange property.
Here are some key things you are required to do:
- Make sure the exchange property is of like-kind.
- Utilize a qualified intermediary to receive the funds from the initial sale of property and manage the exchange. This ensures that all requirements necessary to satisfy the exchange are followed.
- Comply with the deadlines.
Potential Pitfalls of 1031 Exchanges
While these types of transactions occur quite frequently, being aware of the following common pitfalls will help you avoid an unwanted outcome from your exchange:
- The receipt of cash or non-like-kind property, called boot, can trigger a gain (e.g., the value of fixtures, washers/dryers, or other equipment in an apartment building transaction).
- Reduction in debt can also be considered boot and subject to gain recognition.
- If an exchange deal falls through, the third-party intermediary may hold on to sale funds for the entire 180 days.
- Property taxes may be owed on the exchange purchase (discoverable during escrow), which will require a cash payment at the time of closing and, thereby, trigger the recognition of taxable income.
Want to learn more about 1031? Contact our tax team!
A 1031 exchange can be used to defer tax on the sale or transfer of your property. I recommended you consult with your tax professional when deciding whether an exchange is the best option for you. Weinstein Spira can assist by assessing your tax situation, identifying qualified exchange intermediaries, and helping to ensure an overall seamless experience.