A real estate investment can excite you to a great extent. However, it would help if you studied it as an investor before investing. Otherwise, you will find yourself in a no man’s land at some point in time during the transaction, particularly when it comes to 1031 exchanges. Section 1031 of IRC, loosely termed as a 1031 exchange, lets you defer capital gains tax on swapping an old property with a new like-kind property. However, that’s only one aspect of 1031 exchanges. Besides, a 1031 exchange offers many more benefits and requires investors to follow a set of guidelines for receiving these advantages.
‘Like-Kind’ restriction in 1031 exchanges –
In 1031 exchanges, the term like-kind is deliberately used to describe similar properties. In other words, you can only swap an investment property with another income-producing asset and not with a primary residence. So, you cannot defer taxes taking advantage of this unique investment structure if you use your new property differently. The IRS has clearly mentioned that the subject properties must be income-producing assets. However, it doesn’t mean that the old and new 1031 properties should be used in the same way. For example, you can sell a student-housing building and reinvest the proceeds in a multi-family apartment or industrial property.
You can invest in multiple assets at one time.
As long as you don’t exceed your old property’s current value, you can acquire as many replacement properties as you want. The IRS has established the following property rules for 1031 investors –
- The Three Property Rule – You are allowed to identify up to three replacement properties irrespective of their price. Plus, you don’t need to acquire all of the identified properties.
- The 200% Rule – You are allowed to identify any number of replacement properties as long as the total value of all properties doesn’t exceed 200% of the price of the old property.
- 95% Rule – You can identify any number of replacement properties as long as the value of the asset acquired at the closing of a 1031 exchange is at least 95% of the old property’s price.
As you can see, the IRS gives you enough flexibility when it comes to property identification. However, you should not take anything for guaranteed in 1031 Exchanges. One of the 1031 rules states that a 1031 exchange will no longer be valid if any gain is recognized at the end of the transaction. The extra amount if called ‘Boot.’ A Boot is defined as ‘something given in addition to.’ In 1031 Exchanges, it is the additional amount of money or the outstanding balance at the end of the deal.
Not always boot results due to cash. In 1031 exchanges, you can receive boot in one of the following ways:
- Cash – Cash boot is the money saved by the investor at the end of a 1031 Exchange. Say, you sold your old property for $500K, and your replacement property costs $400K. Now, if you proceed with the transaction, you will have $100K as capital gains at the end of the exchange. This amount will be taxed normally.
- Debt Reduction – Say, your old property had a $300K debt, whereas you took $150K as a loan for your new property. The difference between both amounts, i.e., $150K is the boot in this case.
- Sale Proceeds – If you end up spending a part of your proceeds from the relinquished property on non-qualified expenses like utility bills, escrow agent’s fee, etc., it will immediately nullify your chances to defer capital gains taxes.
Borrowing more than what is required can also result in a boot. Therefore, you must calculate everything before applying for a property loan.
What should you know about your 1031 property identification?
When you opt for a 1031 exchange, you get 45 days’ time to identify replacement options, which begins the day you sell your old property. The IRS requires you to send written identification of properties you identified within this time limit. You cannot change your mind after submitting the property details to the IRS.
How does property identification work in 1031 exchanges?
After selling your old property, you must immediately do the following two things –
- Hunt for one or more potential replacement assets. Try to submit property identification before the 45th day.
- Submit details of the identified properties, like location, price, area, etc., to the IRS before the deadline.
Your 1031 identification document should contain all details of the new property, including the street address. You must also mention the property type in the identification papers.
What if you don’t want to acquire the entire property but a portion of it?
Say, the property you identified needs to be fixed. In such a case, you must describe the identified property and the improvements it requires in as many details as possible. Now, let’s consider you don’t want to buy the entire property and only want a specific portion of it. Do 1031 exchange rules allow you to do that? The answer is positive. You can buy a specific portion of a property and not the entire asset as your 1031 replacement property. But you need to mention the exact interest percentage in the identification papers.
You have the luxury to substitute new replacement property by revoking the previous identification and correctly identifying new replacement properties in writing during your identification period. However, you may not be able to make any changes once your 45 days end.
We recommend that you speak to a 1031 expert or a tax advisor before investing your sale proceeds.