A 1031 exchange is a great way to defer taxes on capital gains or depreciation recapture. Although this tax savings tool has been around for decades, there are still some common misconceptions as to how exactly it works.
1) 1031 exchanges are only for real estate. A 1031 exchange can be used for a large variety of asset types that are held for investment or used in a trade of business, including, but not limited to, aircraft, cars, trucks, rail cars, agriculture/construction/manufacturing equipment, and even artwork.
2) “Like-kind” means I must exchange the same type of property, such as an office building for an office building. When it comes to real estate, the type of property you exchange doesn’t have to be the same or even similar. For example, you can exchange an office building for a farm and vice versa. The term “like-kind” deals with broad categories, such that a parcel of real estate can’t be exchanged for a piece of art and construction equipment can’t be exchanged for an airplane.
3) In order to complete a 1031 exchange, I must first find someone to “swap” property with. You are not required to “swap” property with one person. In fact, you are free to sell your property to one person and buy your replacement property from someone entirely different.
4) I have to sell my property first before I can buy a new one. While this type of exchange is the most common, you also have the option of buying the new property before selling your existing one. This is referred to as a reverse exchange.
5) The sale and purchase must take place simultaneously. From the date of closing of the relinquished property, the exchanger has 45 days to identify their replacement property and 180 days or the due date of their tax return (including extensions), whichever comes first, to close on the replacement property.
6) All of the funds from the sale of the relinquished property must be reinvested. In order to defer 100% of the tax associated with the sale of the relinquished property, all sales proceeds must be used to acquire replacement property. Partial reinvestment is also possible, but will typically trigger gain upon the sale, resulting in partial tax deferral.
7) If I sell one property, I can only exchange into one property. You can sell one property and exchange into multiple properties and vice versa, as long as all of the rules are followed.
8) 1031 exchanges are just for big companies and investors. Anyone who owns qualified business or investment property, whether large corporations or individuals, can utilize a 1031 exchange.
9) I don’t need to use a Qualified Intermediary (QI). While using a QI for an exchange is not required, the IRS provides “safe harbor” procedures for 1031 exchanges with QIs. So using a QI helps ensure the highest chance of success for your exchange.
10) It doesn’t really matter who my QI is. The right QI can make the difference between a successful exchange and a failed exchange. Before selecting a QI, make sure you’ve found one with high levels of experience and expertise who knows how to handle your type of exchange. Make sure your funds are held in a segregated escrow or trust account and not commingled with other exchangers’ funds.
What is a 1031 exchange? Find out more by downloading our 1031 Exchange Kit.
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