1031 Exchange – What You Should Know

Posted on Aug 31 2016 - 6:01pm by Editorial Staff

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People who deal with taxes for a living may be able to recite Internal Revenue Code sections like the alphabet. For most of us though, we never get past retirement plans. However, if you have a sizable property portfolio, you’ve probably heard “section 1031” pop up in conversation and journals a lot lately. Like many, you may be wondering what exactly this means. In the simplest terms possible, a 1031 exchange is a trade of one asset for another with no or limited tax. The details go far past this, but here are some of the basic things every investor should know about a 1031 exchange.

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First of all, you have the option to do a delayed exchange. Traditionally speaking, an exchange is the simple swapping of one property for another between two people. However, the chances of finding the exact property you had in mind owned by someone who wants your property are pretty slim. Due to this inconvenient truth, a lot of exchanges these days are delayed (sometimes called three-party or “starker” exchanges.) You’re free to take advantage of this exchange model, but you have to designate a qualified intermediary. This intermediary acts as a kind of middle-man between you and the other party. They hold onto the capital after you “sell” your asset, and then uses it to “buy” the replacement property. Though it involves three parties, this exchange is treated as a swap.

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One of the more inconvenient things about a 1031 exchange is that you have to designate a replacement property. This is one of the two main rules which you need to follow if you want to reap all those juicy tax benefits. Once the sale of your first asset occurs, your intermediary has to receive the capital from the property. If you receive the cash directly for the sale, you’ll be sacrificing any reduced tax that you were hoping for. Furthermore, you’re required to designate a replacement property in writing to your intermediary within 45 days of the original sale. Many investors have really shot themselves in the foot by ignoring these rules, so make sure you don’t end up one of them!

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Finally, be aware that you can specify more than one replacement property. I spoke to some property investors recently, and a debate started up about how many properties you can designate in the course of a 1031 exchange, and the conditions you’re allowed to impose. The IRS has said that you can designate three properties as designated replacement properties, provided that you close on at least one of them eventually. However, if you qualify on certain valuation tests, you can designate even more properties. For example, if the fair market values of your replacement properties doesn’t go over 200% of the aggregate fair market value, then you can designate an unlimited number of replacement assets. Do your own research, and find out where you stand on the amount of replacement properties you can designate.

While we’ve only really skimmed the surface, I hope this post has simplified the 1031 exchange for you.

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Editorial Staff

Editorial Staff at I2Mag is a team of subject experts led by Karan Chopra.