6 Steps to Understanding 1031 Exchange Rules

Obtaining its name from section 1031 of the Internal Revenue Code (IRC), a 1031 exchange enables investors to move property without paying certain taxes such as federal and state capital gains. This tax strategy enables the growth of portfolios and net worth to increment faster and more efficiently than possible. Here are steps through which you can understand the 1031 exchange rules.

Understand the IRS definition of 1031 exchange

The very first step of understanding the rules of the 1031 exchange is getting the proper definition by the Internal Revenue Service. The IRS defines 1031 exchanges as like-kind exchanges. A like-kind exchange is an exchange of business used property or property held for investment purposes for another property of the same type used for business or held for investment purposes. Unless investors exchange property that is not like-kind, they cannot declare gain or loss through 1031 exchange.

Eligible properties

The second step is to understand which properties are eligible for the 1031 exchange. As the IRS defines the properties as like-kind, as long as the properties are of the same type, you can exchange them regardless of size or quality. For example, you can exchange a small apartment for a large one. Some rules govern the kind of property eligible for this exchange;

• You must hold the property for productive use by business or investment purposes.
• The assets must be tangible. For example, shares of stock do not qualify here since they are intangible.
• You must identify the asset as separate from other property you own.

Knowing whether your property qualifies for a 1031 exchange is vital for participation in this type of exchange.

Understand the five common types

The 1031 exchange explained here has five common types that are often used. The nature of the exchange determines the type of exchange to be used. Knowledge of these types will help you determine the most suitable for you.

Delayed exchange

In this type of exchange, the replacement property is delayed, and the IRS gives a window within which the purchase should be closed. Normally, designation takes 45 days, and the purchase is completed within 180 days.

Simultaneous exchange

In this type, there are no delays since the replacement property is purchased immediately after the previous property has been sold.

Reverse exchange

You can acquire the replacement property before the previously owned property is sold.

Build-to-suit exchange

This exchange happens when a property built to suit the investor’s needs is used to replace a property they have sold.

Simultaneous Build-to-suit exchange

When the property is built to suit the investor’s needs and is meant for replacement purposes is bought before the current property is sold.

Understand the time frames

The IRS defines the period within which the exchange property is designated and when the exchange should be closed. This necessity is brought about by delays triggered by the complexity of finding the same kind of property and person willing to sell.

45-day period

Forty-five days is allowed by the IRS for identification of the replacement property. A designation of the replacement property is made to an intermediary in writing who will receive the money on your behalf.

180-day rule

This period is when you have to close the purchase of the replacement property. This period does not start at the end of the 45 days of designation but starts immediately from the sale.

Get an intermediary

One of the rules of section 1031 requires the use of an intermediary who conducts the exchange on your behalf. Receiving the money yourself violates the rule. It will not be considered an exchange but a sale subject to capital gain tax.

Understand the financial implications.

This exchange has various financial implications on taxes. It is beneficial to investors who want to roll over the capital gain tax until they sell the property. Tax savings depend on the type of property and eligibility to participate in this exchange program. However, in some cases, an amount known as a boot is counted and is subject to capital gain tax, which is less than the capital gain tax that results from a direct sale.

These steps will help you understand the 1031 exchange rule, which will help you as an investor generate much revenue from your investment by reducing tax costs.