1031 Exchange Misconceptions


1.“Like-kind” means I must exchange the same type of property, such as an apartment building, for another apartment building.

Like-kind is an unfortunate misnomer within the context of real property. 1031 exchanges are often called “like-kind exchanges” because that is the language used in the tax code. And there’s the rub: “like-kind,” in effect, simply means that as long as you’re selling real property somewhere in the USA and then buying/exchanging into some other real properly located somewhere in the USA, then you’re OK. Exchanges can be done anywhere in the country and can cross state lines. If you sell a rental condo, you do not necessarily have to exchange info another rental condo! You could exchange into raw land, or a strip shopping mall, or a commercial office building, etc.

I know you’re thinking, “whosawhatsit technical, legal mumbo jumbo.” Me too… I read this stuff all day long. The bottom line is any property that you don’t owner occupy that yields rental income. Simple, huh?

So let’s recap: all real property is like-kind to other real property. Although most 1031 exchanges are done with real property, exchanges can be done with aircraft, artwork, machinery, business vehicles… just about anything that has a capital gain tax can be exchanged. We call these non-real property items “personal property.” The term “like-kind” means that you can’t exchange an apartment building for a
Leer Jet. You can’t exchange machinery for artwork. But in the context of real property, always remember that all real property is like-kind to all other real property.

2. A1031 exchange means that the sale and the purchase have to happen at the same time. In other words, the seller has to find someone willing to swap properties.

The Odds of findings someone else with the exact property that you want – and who wants the exact property you have – are slim. For that reason the vast majority of exchanges are “delayed exchanges” in which you can sell your investment property to anyone wanting to buy it . Yu need t use a special “middleman” called a Qualified Intermediary (“QI”) or Accommodator who is required to hold the sale proceeds for you and who then uses those proceeds to buy any replacement for you and who then uses those proceeds to buy any replacement property that you want.

3.My attorney can handle the exchange for me as my Qualified Intermediary (QI). Or, my accountant knows all my tax stuff – I’m going to use my CPA as my QI.

If the seller’s Attorney or accountant has provided any legal or accounting related services ( or any service not exchange related ) in the two-year period before the exchange , they are disqualified and may not act as the Qualified Intermediary.

4.To do a 1031 exchange I just need to file a form with the IRS with my tax return and “roll over” the proceeds into a new investment. As long as the seller doesn’t touch the sales proceeds, he can do an exchange any time.

A valid exchange requires much more than just reporting the transaction on Form 8824. One of the biggest “no-no’s” in structuring an exchange is allowing the taxpayer to have actual or constructive receipt of the sales proceeds.  This could trigger a taxable event.

Another “whosawhatsit” … geez. DON’T TAKE THE MONEY! Absolutely and NO KINDA WAY shuld you allow the proceeds of the sale end up in your bank account. Don’t take a check, don’t have a wire transfer. “If you do… you may be subject to paying capital gains taxes. The whole point of a 1031 exchange is to defer paying the capital gains tax.”

The QI must hold the sale proceeds during the curse of exchange. There are specific deadlines that must be adhered to as well. You have 45 calendar days, starting from the date you close on your sale , to simply identify the possible replacement properties you might want to buy. Then you have 180 days (again, starting from the day you close on the sale) to close on the purchase of one or more of the properties identified.

Translation:

You’ve got 45 short days to find a replacement property… you have no idea how short 45 days is until you are up against the clock of a 1031 Exchange and YES, Saturday and Sunday count. Then you have upto 135 days to close escrow on the new property/properties. That is total of 180 days from the date of the closing of your sold property.

5.The capital gain tax rate is only 15%. I’ll just bite the bullet and pay the taxes now.

Think twice about that! Capital gain tax rates have changed significantly starting in 2013. Your capital gain tax rate might be 15%, or possibly 18.8% or even as high as 23.8% (depending on your income level, and subject to the new 3.8% Medicare surtax). And since you are selling investment property, there is probably the recapture of depreciation. The depreciation recapture tax rate is 25%. A non-exchanger will also have to pay the tax at the state level as well. In most cases, the state tax on the sale of real estate can also be deferred by doing a 1031 exchange. In summary, if you do not exchange and simply pay the tax now, you could have an effective or blended capital gains rate as high as 35% to 40% (State tax + depreciation recapture + new capital gains rates).

This is the crazy part. Do you know what AMT is? Alternative Minimum Tax. So here’s the deal. If your income is higher than $250K annually, you may be subject to AMT. Which means you could have purchased a building in two thousand whatever or prior (1995 let’s say) and the difference between what you bought it for, $150,000 and currently selling it for $900,000 the difference is $750,000. You could possibly wind up paying 50% of your gain in capital gains taxes! HOLY COW! Lets get real. If you had the personal choice to give $375,000 to any current member of the US Congress to do with whatever they wanted, would you?

6. Alt of the funds from the sale of the relinquished property must be reinvested.

A taxpayer or exchanger can buy down in value. Or a taxpayer can choose to withhold funds or receive other non-like-kind property in an exchange. But the amount that they buy down, or money they withhold, or any other non-like-kind properly received, is considered “boot” which means the exchanger likely will have to pay some taxes.

If your objective is to keep as much of your money as possible and make it work for you… would you sell a property for $900,000 and only purchase $300,000 of real estate? Probably not. You want it as much of the sale proceeds as possible to work.

7. You must replace the debt that you had on the relinquished property with at least the same amount of debt on the replacement property.

The exchanger can always bring their own cash to the closing table for the replacement property to offset any reduction in debt.

This is easy… you sold for$900,000 you want to replace at least $900,000 on the other end.

8. Exchanges are complicated and are only for big investors.

Exchanges don’t have to be complicated! A good Qualified Intermediary will work with you and your tax or legal advisors to make sure the process is done correctly and as seamlessly as possible. And exchanges are not just for big investors: No amount is too small or too large; anyone owning investment property that has a gain (the market value greater than its adjusted basis) should consider a 1031 exchange.

9. When I sell my home – where I live with my spouse and the kids and our pets – I should do a 1031 exchange.

Tax-deferred exchanges are not for real property held for only personal use. 1031 is for investment property only: you cannot 1031 exchange your personal primary residence for another home.

There is another part of the tax code that already allows you to sell your home and avoid capital gain tax. But there are ways to use 1031 to exchange mixed-use rental / vacation homes within certain parameters. Consult your QI and tax advisor for more information.

10. If you sell one property, you can only exchange into one property.

You can sell one properly and exchange into multiple replacement properties. And the other way around as well: you could sell multiple properties and exchange into one larger and more easily managed property. You can buy or sell any number of properties in an exchange. The devil is in the details, so choose a good QI to help you.

11. 45 days & 180 days are written in stone.

You cannot manipulate, alter, play with, cajole or in some way change the timeline. If you close escrow on March 1st, your 45th day to declare the replacement property is May 16th. Whether May 16th is a Sunday or a Tuesday the last day that you have to clarify the replacement property is always 45 days after the closing of the sold property. You must close escrow on the 180th day or your exchange is blown. I can’t tell you how many people; I have spoken to who have said… “in the past we could”… blah, blah, blah. Not anymore. The first thing to do when you close escrow is to look at your calendar and mark the 45th and 180th day on your calendar.