1031 Exchange – Why They Are Important

What is a 1031 Exchange? It is called that because that is the section of the tax code that defines what they are and how they need to be done. They are also called like kind exchanges or Starker exchanges. They are primarily used in real estate but can be used for other types of property as well.

Tax Free Swaps or Exchanges

So what is it? It is a swap of one investment asset or one business for another. Normally when you sell one and buy another there is capital gains tax to pay. If you follow the 1031 rules you will have little or no capital gains tax to pay when you exchange one property or business for another. Forbes has a nice little article on them.

Tax Deferral

This allows you to continue to grow the asset or business tax deferred. That is a huge bonus because you can leverage that money you didn’t have to pay in capital gains taxes into even more growth. Plus, you can do it as many times as you want. There is no limit on the number or frequency. (Always check with your lawyer and accountant to make sure nothing has changed.)

You don’t pay tax until you finally sell without doing a 1031 exchange. Using this method almost guarantees that you will pay only long term capital gains and not short term which is generally a much lower tax rate.

The rules are very specific for 1031 exchanges. Don’t try to do this on your own. Definitely use an attorney who has done a number of these so you don’t mess up and find you owe a lot of taxes.

Key Features to Be Aware Of:

– For business and investments only, no personal assets like your home

– You can’t exchange partnership interests or corporate stock. You can exchange paintings.

– It must be a like kind exchange. However like kind is fairly loosely defined but there are little twists that you need to be careful of.

– Delayed exchanges – You can’t always find something to buy of like kind immediately. If you have a middle man hold the money and then buy the new asset for you, it can still qualify despite not being a direct transaction.

– Designate the replacement – You must specify what you will buy within 45 days of selling your asset or business. Many people create a list of possible properties so they have options in case one falls through. If you take any money from the sale before the purchase is made it negates the 1031 exchange.

– There are rules about listing multiple properties. The IRS says 3 as long as you close on 1. But you can list a number as long as the value of all of them is not more than twice the value of the property being sold.

– You need to close on the new property within 6 months of selling the old one.

– Some tax if what you buy is less than what you sell. You are taxed on the difference in the two prices.

– Decreased debt will be taxed. If your mortgage on the new property is less than the mortgage on the old property, then that is considered a gain and the difference will be taxed even though you received no cash.

– No tax ever! How? Die! If you have done 1031 exchanges and have lots of capital gains and have never sold the property, when you die, you get a stepped up basis. The property is now valued at the value it had on the date you died and not the value you bought it for. So that effectively means no tax is ever paid.

These are most of the main points you need to worry about with a 1031 exchange. You can see why it is recommended that you use someone familiar with them to guide you through the process.