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Three Notable Problems with 1031 Exchanges
There are many rules and regulations that govern the completion of a 1031 exchange, which often make the process nerve racking for investors. Fortunately, there are many resources available to investors, including the Realized guidebook on the 1031 exchange process. Below are three common challenges of 1031 exchanges and potential solutions for each.
History of the 1031 Exchange
If you're just learning about 1031 exchanges, a good place to start is section 1031 of the Internal Revenue Code (IRC), which states that if an investment property is exchanged for a “like-kind” investment property, taxes on capital gains can be deferred. For this reason, a 1031 exchange is an excellent wealth-building strategy, leaving investors with more equity to reinvest in more valuable properties.
Investment Properties That Don't Qualify For a 1031 Exchange
When you sell an investment property for more than what you paid for, you will likely incur a capital gain and have to pay taxes on it at the time of sale. However, Internal Revenue Code Section 1031 provides an exception to this rule if you reinvest your capital gains into a similar property. This type of transaction is referred to as a “like-kind exchange," allowing you to defer the taxes you would have otherwise had to pay. Fortunately, the exchange rules are fairly broad and allow investors a great deal of latitude in their choices.
Two Big Challenges of 1031 Exchanges
Every year, hundreds of thousands of investors subject themselves to the anxiety that comes with the challenge of completing a 1031 exchange. That anxiety, however, is avoidable. In this post, I’ll lay out the two major exchange challenges investors often face, and how to overcome them. The key to avoiding anxiety is to plan ahead, before you sell a property.
Non-Real Estate 1031 Exchanges
Did you know that 1031 exchanges aren’t just for real estate? In fact, you can exchange much more than you might think. For example, a farmer could exchange a herd of cows for another type of livestock, and in doing so defer capital gains tax. How is this possible?
What is 1031 Exchange Boot?
Although not specifically defined (or even mentioned in IRC Section 1031), the term “Boot” is a vernacular term and used frequently. It refers to the fair market value of cash, benefits, or other non “like-kind” property that a taxpayer receives in an exchange, and which is subject to capital gains tax. The determination of 1031 exchange boot can be tricky, because it can include any item in an exchange that is not considered like-kind as defined under IRC Section 1031.
What is a 1031 Exchange?
There’s been a lot of buzz about 1031 exchanges lately, but they are nothing new. Savvy real estate investors have been using them to defer taxes since 1921. It’s a common, fairly straightforward strategy that allows real estate investors to sell (or as the IRS calls it, “relinquish”) an investment property, while deferring capital gains taxes on the profit by reinvesting the proceeds in a “replacement” investment property. It’s arguably one of the most effective ways to build wealth, and a tool that every real estate investor should know about.
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