Section 1031 of the Internal Revenue Code is an element of the tax code that property investors shouldn’t ignore.
If you’re a property investor looking to make a profit from your investment, you won’t want to pay the big tax bill that might be facing you.
You don’t have to pay a tax bill like that thanks to the 1031 exchange process.
Before you attempt a 1031 exchange, here are ten things you need to know
Business Use Only
Property investment can be a hobby for some, but the IRS views it as a business and will tax you accordingly.
You can only use any exchange under section 1031 for properties that are primarily used as investment vehicles or for business use. That means you can’t take any profit out of your residential home using an exchange.
Vacation properties are the one exception to personal homes that are exchangeable, but there are some caveats.
If it’s a rental, you can conduct an exchange on it, but you can’t just declare it as a rental. You will need to show 6 months to a year of rental usage, and the longer the better.
You also won’t be able to move into any swapped property for at least 12 months afterward.
Delayed Exchanges Are Possible
In an ideal world, you and another property vendor will be ready to exchange at the same time. Unfortunately, we don’t live in an ideal world, and finding a like-for-like replacement isn’t particularly easy.
Thanks to the 1031 exchange process, you can conduct a delayed exchange, where a third party holds the cash from the ‘sale’ of your property to buy a replacement at a later date.
This isn’t a strict swap but will count as an exchange.
They’re Not Tax-Free, But You Can Defer Them
One of the most important benefits of an exchange under section 1031 is the tax benefits it gives you.
You still technically have to pay tax on an exchange, but you can defer your tax payments forever.
It’s important to follow 1031 exchange rules for 2018 because you might find yourself audited by the IRS if your tax affairs aren’t in order. Here’s some advice on what to do if you find yourself audited by the IRS.
Property Size Is Important
If you’re looking to make an exchange, you have to ensure that the property you’re investing into is equal or greater in cost or value than your previous property.
If you don’t, you’ll be liable for tax on any cash that remains after the exchange. This can be a hefty addition to your tax bill, so it’s best to be sure before you agree to an exchange.
Beware of Liabilities
The number of liabilities you have on your current property must also play a factor in your considerations before an exchange under section 1031.
This means any mortgages or secured debt on your new property must be equal to or greater than on your previous. You can’t gain tax benefits for reducing your debt, unfortunately.
45 and 180 Day Time Limits
Strictly speaking, you have two limits on your time to consider when you’re looking to make a property exchange.
You have 45 days to declare potential new properties if your exchange delays, or the exchange under section 1031 will be void. You must also complete the exchange in 180 days (6 months) after disposing of your first property.
Avoid Receiving the Cash
If your exchange delays, you should avoid the temptation to hold the cash yourself. Handling cash from the ‘sale’ of a property under exchange will void the exchange and result in huge tax penalties.
Using an exchange specialist company or an intermediary will resolve this issue. The cash remains outside of your authority and will be an acceptable arrangement for the IRS.
If you need help with an exchange, you might need to hire the help of specialist 1031 exchange companies. Learn more about what an exchange company can do for you.
You Can Include Personal Property Sometimes
As we’ve already mentioned, exchanges under section 1031 are primarily for investment or business exchanges. There are some ways personal property are exchangeable, however.
Most exchanges will be real estate properties, but you can swap other assets like artwork or cryptocurrencies. Just be aware that it’s not guaranteed that the IRS will accept the exchange as appropriate.
Here’s the lowdown on using the 1031 exchange process for cryptocurrencies.
You Can Choose More Than One Replacement
If you’re ready to make an exchange, then you should be aware that you don’t need to replace one for one other. You can use the cash from your exchange ‘sale’ for more than one property, or a different type of property.
There are some rules for you to consider. Up to three ‘new’ properties are exchangeable for any value, or the overall value must not be greater than 200% of your previous property value.
Exchanges beyond these figures will likely void any potential exchange, with the loss of tax benefits.
Navigate the Pitfalls of a 1031 Exchange
For property investors looking to reinvest their profits into a new property, a 1031 exchange such as a Delaware State Trust is the perfect way to do it.
You can permanently defer your capital gains tax bill, and you don’t have to have a property to invest in straight away thanks to the 180-day time limit. If you’ve got a big profit to reinvest, you can even invest in more than one replacement.
Be careful to navigate around the potential pitfalls, like avoiding taking out your cash too quickly.
Got your own tips to share? Drop us a comment below, and check out our other money articles for more financial advice.