Understanding 1031 Exchange Rules

Feb 18, 2022 Reading time : 6 min

If you have an income property and are considering selling it and purchasing another, you should be aware of the 1031 tax-deferred transaction. Suppose you’re a property investing rookie and are unfamiliar with the term, then you’re at the right place. This article will assist you in understanding the 1031 exchange rules.

A 1031 exchange is subject to many regulations, and you must follow them precisely to avoid a hefty tax fee from the Internal Revenue Service.

Experienced property investors understand that 1031 exchanges are a common tax approach that allows them to expand their holdings and raise net worth quickly and affordably than would ordinarily be possible. 

Therefore, what is a 1031 real estate exchange, how can it function, what are the various kinds, and how do you escape common pitfalls?

Since a 1031 transaction can be complicated, you should probably seek advice from a qualified tax professional before deciding on the best way to go. 

You can check out 1031 exchange real estate rules by D. Clarke, however, here are some fundamentals about how 1031 exchanges work.

1031 Exchange Definition

1031 exchange is a process that permits the proprietor of an investment real estate holding to sell it and purchase a similar building while postponing capital gains tax.

One vital rule to remember about 1031 transactions is that they are typically used for commercial or investment buildings. 

Personal property, such as your residence or a holiday home, does not easily qualify. Also, stocks, bonds, partnership interests, debt instruments, certificates of trust, and inventory are typically not sufficient for 1031 exchanges.

There is no limit to how often you can perform a 1031 exchange. Gains from one unit of investment properties can be carried over to others. 

Even if you make a profit on each exchange, you don’t have to pay taxes on it until you sell it for cash years later. Afterward, if everything goes as planned, you’ll only have to pay property exchange tax once at a specified long-term capital gains cost.

Most swaps must be of ‘like-kind’; an ambiguous term that doesn’t imply what you assume it does. You can swap an apartment block for undeveloped land, or a plantation for a mall. 

Interestingly, the rules are relaxed. You can even swap businesses. There are, however, pitfalls for the unwary.

1031 Tax Exchange Rules

The main advantage of a 1031 swap overselling one property and purchasing another is tax postponement. A 1031 exchange lets you delay capital gains tax, allowing you to invest more capital in the replacement real estate.

Most exchanges are subject to taxation at sales, but if yours fulfills the 1031 prerequisites, you’ll either pay no tax or only a small amount of tax at the period of the exchange.

Depreciable Property Rules

Depreciation represents the portion of an investment structure’s cost that is written off each year to account for wear and tear. 

Whenever real estate is traded, capital gains tax is calculated using the structure’s net-adjusted framework, which is the initial purchase value plus capital improvements minus depreciation.

When exchanging a depreciable building, special conditions usually apply. It can result in a profit called depreciation recapture and is levied as ordinary income. 

You can generally escape this recapture by swapping one structure for another. However, if you swap improved acreage containing a property for unimproved grounds without a building, the depreciation you claimed earlier on the structure will be reclaimed as ordinary income.

1031 Exchange for Residential Property

Single-family residences are one of the most prevalent property types used in 1031 exchanges. Other residential units that can be used include duplexes, apartment complexes, condominiums, townhomes, quadplexes, and mobile houses affixed on the ground.

1031 Exchange for Rental Property

A rental property might require you to settle recaptured depreciation. The IRS lets you depreciate rental real estate because they believe they have limited lifespans and lose value each year.

Every year, you can deduct the depreciated value from your taxes, which is a significant benefit of owning rental real estate. Nonetheless, if you trade the rental unit for more than the depreciated amount, you’ll be required to repay the taxes you saved.

1031 Exchange Rules and Timelines

An essential aspect of understanding 1031 exchange rules is knowing the periods in which you can complete a transaction. An exchange is traditionally defined as a swap of one structure for another one between two individuals. 

However, the chances of locating someone who has the exact property you want and wants the precise one you have are minimal. As a result, many swaps are three-party, delayed, or Starker transactions.

A professional intermediary (middleman) is required in a delayed swap; they’ll retain the cash once you “sell” your real estate and use it to “purchase” the replacement property on your behalf. This three-way transaction is classified as a swap. 

There are two critical timing rules to follow in a delayed swap:

The 45-Day Rule

This rule is concerned with the selection of a replacement structure. The cash will be given to the middleman once your property has been sold. You can’t accept the cash because it’ll jeopardize the 1031 treatment. 

Furthermore, within 45 days after selling your real estate, you must assign the replacement property in written form to the middleman, naming the property you wish to acquire.

According to the Internal revenue service, you can assign three structures as long as one of them is eventually sold. You can even assign more than three properties if specific valuation tests are met.

The 180-Day Rule

The other timing regulation in a delayed swap is the closing rule. You must finalize the transaction on the new real estate within 180 days after selling the old one.

Keep in mind that 180 days doesn’t equal six months. The IRS calculates the 180 days by counting each consecutive day, including holidays and weekends (including federal holidays).

Bottom Line

A vital aspect of understanding 1031 exchange rules is knowing about all the different kinds of properties available and the regulations guiding them. It’ll widen your investment options and let you pursue a more diversified tactic. 

So, ensure you make enough inquiries and do your due diligence before embarking on a 1031 real estate swap.

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