Demystifying a 1031 Exchange

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Craig W. Smalley, EA
Founder/CEO
CWSEAPA LLP
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A 1031 Exchange comes from Internal Revenue Code 1031 and it is mostly utilized in the real estate realm, but can also be done with business assets that your clients should be aware of.

If you have ever traded your car in, then essentially you have just done a like-kind exchange. For instance, if the vehicle you traded in didn’t have any notes attached to it, you were given $4000 for the trade. That $4000 would be added to the basis of the new car.  Just imagine that on a grander scale.

There are basically four different kinds of 1031-type exchanges, with the most common type explained in detail below.

A simultaneous exchange involves both parties exchanging deeds, and everything is taken care of. That is a true like-kind exchange. However, they are never really that simple. 

Usually someone wishing to do a 1031 Exchange will have to find a qualified intermediary (QI). At closing of the first property, the QI would take possession of the cash and hold it.

The person that sold the property has 45 days to identify up to three properties to roll over the proceeds of the sale of the property. Why three properties?  Because deals fall through.  After the properties have been identified, you then have 180 days or the due date of the tax return including extensions, whichever comes first, to take possession of the property.

There are no rules officially stating this, but many Tax Court cases have put forth that you need to hold the new property for at least two tax returns before relinquishing it again.

And then what have you really accomplished? You haven’t avoided capital gains, you have just prolonged them. Now conceivably, you could exchange one property into another property, i.e. rent the second property out. 

You could then do a 1031 into your dream home, rent it for two years and convert it to your personal residence. If you have lived there for two of the last five years and then sell it, provided that you make less than $250,000 if you are single or $500,000 if you are married, then you avoid capital gains tax altogether.

There are other ways to avoid capital gains on the sale of a business or real estate. You can start an irrevocable trust that takes possession of the property. Eventually, you will receive money through an installment sale. 

Since you pretty much control the payments from the trust, you also control the timing of the capital gains. Then at some point, you can sell the property within the trust and cancel the installment note. This must be done correctly, because there are several Tax Court cases that address this very issue.

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