A 1031 exchange, also known as a “Starker” or “like kind exchange,” refers to the swap of one asset for another. While it is most often used in real estate, the 1031 can apply to just about any business or investment asset. The 1031 allows for the changing of a form of investment without ever cashing it out and receiving a gain, allowing it to keep growing tax-deferred. Within the 1031 criteria, there’s often no tax payment required, or just limited tax. There is no limit to how many times this can be done, which means that taxation can be avoided until the final sale of the investment, when long-term capital gain tax will have to be paid out.
While this may seem pretty straightforward, there are actually some potential considerations and complications with the 1031. Here are five important points to be aware of:
1. It’s Not for Personal Use -- Usually
The 1031 can only be used for business and investment property, not in scenarios of swapping a primary home for a different residence. That said, it can be applied in some cases when swapping vacation homes -- we'll discuss that more in #5. Certain interests involving a tenant in common (TIC) can also be 1031’d, and some personal property can be swapped as well, such as in the exchange of valuable antiques or artwork. Exchanges of partnership interests and corporate stock portfolios are not allowed.
2. Depreciation Can Be a Factor
Special rules can apply to certain exchanges, especially when it comes to property that is depreciable. Something called “depreciation recapture” can be triggered, which means that the item is taxed as ordinary income. For example, with built-upon improved land that is exchanged for unimproved land without property, any depreciation claimed on the building in the past will have to be recaptured and taxed as income. This can be avoided by sticking to swaps of like-items.
3. Most 1031s Are Delayed Exchanges
The majority of 1031s are delayed exchanges; this is because it’s rare that the sale of one asset and the purchase of another actually coincide in terms of timing. Delayed exchanges or “Staker” exchanges refer to three party transactions in which a middleman holds the cash after an asset is sold and purchases the chosen replacement property on your behalf. However, once your property is sold, this middleman must first receive the cash for the 1031 designation to be valid. Specific replacement property must be designated to the intermediary in writing within 45 days of your property sale as well.
4. Navigating the Specifics Can Be Tricky
In a delayed exchange, up to three properties can be designated within the 45 day period, as long as you close on one of them eventually. As an alternative, you can also designate unlimited replacements so long as their total fair market value does not exceed 200% of the exchanged property (or properties) total aggregate fair market value. Closing must take place within 180 days of the sale of the previous property regardless of when you designate the new property(ies). Be aware that any cash left over after the deal (such as on reduced mortgage amounts) will be taxed.
5. Second Homes and Vacation Properties
While many investors would love to do a 1031 when selling an investment property to buy a vacation property, this is only possible if certain requirements are met:
The 1031 "Like Kind" exchange can offer tremendous tax savings for investors; just make sure you're using it correctly.
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