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1031 Exchange Basics

1031 Exchange Basics:

Below is information outlining the details of a 1031 exchange. Clients who are interested in tax deduction vehicles should consider this tax deferred option:

  • Why “1031 exchange it”?
    • Allows your investment to continue to grow tax deferred.
    •  In effect, you can change the form of your investment without cashing out or recognizing a capital gain (in the eyes of the IRS)
    •  There is no limit to the amount of times you can exchange. Although you may have a profit on each swap, you avoid tax until you actually sell for cash many years later
  •  Provisions:
    • Must be “like kind” of property
    •  “Like-kind” property is property of the same nature, character or class. For IRS standards, it is defined very broadly.
    • Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment
    •  Consider mortgages and debt: if you receive cash back, it is taxed.
    • If you don’t receive cash back but your liability goes down, that too will be treated as income to you just like cash.
  • Time Limits
    • Identification period
      • Within 45 days from the date you sell the relinquished property, you must identify (in writing) the replacement property.
    • Exchange Period
      • 180 days. You must close within 6 months.
      • However, you can delay the exchange with the use of a three-man swap
      •  In a delayed exchange, you need a middleman who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you.
  • Vacation home loophole
    • Congress has narrowed this loophole to disallow owners to call a property an investment, yet live primarily in that home, or plan to retire to that property.
    • Despite this, Congress has created a safe harbor rule. To qualify for the safe harbor, in each of the two 12-month periods immediately after the exchange:
      • (1) You must rent the dwelling unit to another person for a fair rental for 14 days or more; and
      • (2) Your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
    • An example of a vacation property that would qualify for an exchange despite this narrow loophole:
      • You stop using your beach house, rent it out for six months or a year and then exchange it for other real estate. If you actually get a tenant and conduct yourself in a businesslike way, you’ve probably converted the house to investment property, which should make your 1031 exchange OK. But if you merely hold it out for rent but never actually have tenants, it’s probably not.
    •  If you want to use the property you swapped for as your new second or even primary home, you can’t move in right away
    • If you acquire property in the 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange.
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