For 2024, here are the latest top misconceptions we’ve found that the public has about 1031 Exchanges:
- Reinvesting Rules
- Replacing Debt
- Vacation Home Qualification
- Partnerships
- Related Parties
- Exchange Funds
- Tax Deferral
- Holding Periods
- ID Deadlines & Timing Rules
- Reverse Exchanges
Reinvesting Rules
I only need to reinvest my cash OR only need to reinvest my gain.
FALSE
In a 1031 Exchange, you need to reinvest the entire proceeds from the sale of your property, not just the cash or the gain. This means that to fully defer your taxes, you must use all the money you received from selling your original property to purchase new like-kind property of equal or greater value. Additionally, you need to replace the value of any debt that you had on the sold property. If you don’t reinvest all the proceeds or if the new property’s value is less than the original one, any leftover monies (known as “boot”) may be subject to taxes. This may result in a partial exchange rather than full tax deferral.
Replacing Debt
I’ve paid off my loan at the closing of my Relinquished Property and now I don’t have any more debt to replace.
FALSE
For full tax deferral in a 1031 Exchange, you need to replace the value of any debt paid off on the Relinquished Property. However, this doesn’t mean you have to take on new debt. You can use your own cash or other financing options to make up for the value. For example, you could use personal funds, seller financing where the seller of the Replacement Property finances part of the purchase, or obtain a loan from a private party or a bank. The important point is that the total investment in the new property matches or exceeds the value of what you sold, including both equity and any debt that was paid off.
Vacation Home Qualification
I have never rented out my vacation home that my family and friends use regularly. It qualifies for a 1031 Exchange since it’s an investment property.
FALSE
For a property to qualify for a 1031 Exchange, it needs to be held for investment purposes or used in a trade or business. If you have never leased your vacation home and use it regularly for personal purposes, it does not qualify as an investment property. The IRS requires that properties involved in a 1031 Exchange be held primarily for investment or productive use in a trade or business, not for personal use. To potentially qualify your vacation home for a 1031 Exchange, you would need to lease it and limit your personal use to meet the criteria set by the IRS.
Partnerships
A partnership is able to sell its investment property and each partner can do their own 1031 Exchange with their portion of the proceeds.
FALSE
The IRS does not allow the exchange of partnership interests under Section 1031. This means that individual partners cannot set up separate individual 1031 Exchanges based on their share of partnership property. However with advanced planning using strategies such as “drop and swap”, each partner may be able to set up their own 1031 Exchange. Given the complexities involved, planning ahead by consulting with your tax advisor is strongly suggested.
Related Parties
I can sell my current investment property to a family member or purchase new property from a family member and have a successful 1031 Exchange.
DEPENDS
While you can engage in transactions with family members as part of a 1031 Exchange, there are strict rules and potential pitfalls. The IRS scrutinizes these transactions closely to ensure they are not being utilized to circumvent tax laws. This is often referred to as “basis shifting.” While it is technically possible to conduct a 1031 Exchange involving family members, it requires careful planning and adherence to IRS regulations to avoid disqualification and unintended tax consequences.
Exchange Funds
After I begin my 1031 Exchange, I can cancel at any time and request that the 1031 Qualified Intermediary return my funds.
FALSE
The Tax Code does not permit a taxpayer to cancel a 1031 Exchange at any time. There are restrictions regarding when you can access funds depending on where you are in the exchange process. The “(g)(6)” rules listed under Section 1031 of the Tax Code specifically restrict when and how you can receive your money back if the exchange does not proceed as planned. It’s important to review these rules as part of your decision to structure your sale as a 1031 Exchange.
Tax Deferral
I never have to pay taxes on a 1031 Exchange.
FALSE
Section 1031 of the Tax Code permits taxes to be deferred – but not eliminated. When you eventually sell your new Replacement Property, if you do not structure the sale as another 1031 Exchange, you will owe the taxes that you deferred on previous exchanges. If you have taken depreciation deductions on your investment property, those deductions will be recaptured and taxed as well. In certain cases, if you hold onto the property until your death, your heirs may receive a “step-up” in basis to the property’s current market value at the time of inheritance, potentially eliminating most or all of the capital gains taxes altogether for them.
Holding Periods
I can sell a property acquired in a 1031 Exchange at any time after my exchange.
DEPENDS
There is no strict IRS-mandated minimum holding period for Replacement Property. However selling property too soon may raise questions about your intent to hold the property for investment purposes, which is a requirement for qualifying under Section 1031, and could potentially jeopardize the tax-deferred status of your initial exchange. The consensus among tax professionals is that holding the Replacement Property for at least one to two years may help demonstrate your intent to hold it for investment purposes versus a quick resale. However, under certain circumstances, a shorter period may be allowed. Prior to listing property acquired as part of a 1031 Exchange, consult with your tax advisor for guidance.
ID Deadlines & Timing Rules
The 45th day is flexible.
FALSE
The 45-day rule requires taxpayers to identify the property or properties they are planning on purchasing to complete their 1031 Exchanges within 45 days after the closing of their Relinquished Property. However, with the exception of extensions granted by the IRS due to disasters, there are no extensions regarding the 45-day Identification period. Failure to adhere to the rules set forth in the Tax Code will cause the 1031 Exchange to be disqualified resulting in payment of the taxes the Exchanger was attempting to defer.
Reverse Exchanges
If I need to set up my 1031 as a Reverse Exchange, it will be relatively easy to obtain financing.
FALSE
A Reverse Exchange allows a taxpayer to acquire new Replacement Property prior to selling Relinquished Property and still obtain tax deferral on the proceeds from the Relinquished Property sale. While allowed by the IRS, Reverse Exchanges are more complex than traditional 1031 Exchanges and present unique challenges including obtaining financing. Lenders may have stricter requirements for Reverse Exchanges. They may require higher down payments or offer less favorable loan terms compared to standard purchase loans. Additionally, you may need to work with specialized lenders who are familiar with 1031 Exchanges. While challenging, there are many situations where structuring a transaction as a Reverse Exchange is a great solution. If a Reverse Exchange is contemplated, it is critical that taxpayers confer with their tax professionals prior to signing contracts for the purchase and/or sale.
Investment Property Exchange Services, 2024
