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What You Need to Know About a 1031 Exchange

by KNS Financial on November 9, 2010

Tax Free Exchange (1031 Exchange) Explained

Normally, when you sell investment property, and realize a gain, you must pay taxes on that gain.

However, if you are replacing that property with another one of equal or greater value, you may be able to classify it as a tax free exchange, otherwise known as a 1031 exchange.

Be sure you understand the rules of a 1031 exchange.  Let’s take a look:

Tax Free Property Exchange

A 1031 exchange is so named because it is governed by section 1031 of the IRS tax code. Here is what the IRS has to say about this arrangement:

Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031.

This strategy can be useful to any business owner looking to expand operations. Keep in mind that this does not apply to just any type of asset:

Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.

So, if you have property used for investment and you sell that property in order to purchase another of equal or greater value then you are able to avoid paying taxes on any gain realized in the sale.

At this point your sale and purchase of investment properties are no longer looked upon as two separate transactions, but they are considered to be part of an “exchange”.

Like-Kind Property

In order for your transactions to be considered a tax free exchange, they must be “like-kind” property.

What is like-kind property?

The IRS explains it as follows:

Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.

Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.

This is something very important to keep in mind as you consider taking advantage of a 1031 Exchange. Although, two pieces of investment property are usually “exchangeable”, you still need to be sure.

Boot

It is possible to do a tax free exchange of like-kind properties, but also have property that is not considered like-kind as a part of the deal; however, the IRS has special rules to deal with this:

If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.

Any money or property received that is not like-kind is typically referred to as “boot“. If your transaction includes boot, then you are responsible for paying taxes on your gain, up to the amount of the boot.

For example, if you sell a property with a larger mortgage balance than the property that you buy, you will have to pay taxes on the difference between the two mortgages. You must also consider boot if the seller of the property that you are buying makes repairs to the property as part of the deal. The cost of the repairs may be treated as cash received.

Time restrictions

An investor only has 45 days from the date that the “original” property is transferred to identify potential replacement properties.

He then has up to 180 days (or the due date of the federal tax return – whichever is earlier) from the original transfer date to complete the exchange.

Restrictions on Replacement Property

There are three rules that govern what can be considered as replacement property in a 1031 Exchange:

  1. The Three-Property Rule – You are allowed to identify up to 3 potential replacements, regardless of value.
  2. The 200% Rule – You can identify any number of potential replacements, but their total Fair Market Value (FMV) cannot be more than double the value of the relinquished property.
  3. The 95% Rule – Again, no limit to the amount of potential replacements. However, you must purchase replacement properties with a combined FMV of at least 95% of the FMV of all identified properties, before the end of the exchange period.

There is one thing to keep in mind when determining if a tax free property exchange, or 1031 exchange, is right for you.

This is not a way for you to permanently avoid paying taxes, but simply a way to defer them.

Khaleef writes about personal finance from a biblical perspective for KNS Financial’s “Faithful With A Few” blog. KNS Financial provides Personal Financial advice, Budgeting Assistance, Tax Preparation and Advice, Debt Management, and Economic Commentary, through personal consultations, writing, seminars, and workshops

Reader Questions:

Have you ever taken advantage of a 1031 exchange?

Does this sound like something you will look into in the future?

Do you think that there is too much risk involved given the time restrictions?

photo by woodleywonderworks

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