Changes to the Law in 1984
In 1984, Congress amended some of the 1031 exchange laws in the Tax Reform Act. Specific types of qualified properties were defined, and personal residences were not included. The potential replacement property must be identified within 45 days, including weekends and holidays. Generally, you have 180 days from the date of the transfer of the property to the buyer to close on the replacement property, but there is one exception.
Qualified Properties
Only real estate held for business or investment purposes qualifies for a 1031 exchange. Personal residences and fix-and-flip properties typically do not qualify, as they fall under the prohibited category of property purchased solely for resale. Vacation homes or second homes that are not used as rental properties typically do not qualify for 1031 exchange treatment, but there is a use test under Section 280A of the Tax Code that may apply to those properties. You should consider consulting a tax expert to determine if your second home or vacation home meets the requirements of Section 280A. It may qualify if it is used as a primary place of business or is rented out fully or partially. Land held for development for resale does not qualify for deferred tax treatment. Stocks, bonds, notes, and interests in partnerships are not considered “like-kind” property for exchange purposes.
Purchase Deadlines
Before 1984, all exchanges were conducted simultaneously with the closing and transfer of the sold property or properties and the purchase of the new or replacement property. In addition to challenges faced when trying to find a suitable property, there were difficulties in transferring titles and funds simultaneously. The delayed exchange of 1031 avoids these issues that existed prior to 1984, but stricter deadlines are imposed. An investor wishing to do an exchange lists their property in the usual way. When a buyer comes forward and the purchase agreement is executed, the seller enters into an exchange agreement with a qualified intermediary who becomes the replacement seller. The exchange agreement typically requires the seller’s contract to be assigned to the intermediary. The closing occurs and the intermediary receives the proceeds because the seller cannot touch the money.
Identification of Properties
The first timing restriction, the 45-day identification rule, begins at this point. The investor must close on or identify in writing a potential replacement property within 45 days of closing and transferring the original property. The time period is non-negotiable and includes weekends and holidays. The entire exchange can be canceled, and taxes will certainly follow if the investor exceeds the time limit.
Avoiding “Boot”
Most investors typically follow the three-property rule to allow for serious study and selection of the property that works best for them and will be closed on. The goal is generally to trade to avoid transferring “boot” and keep the exchange tax-free. “Boot” is the money (or the fair market value of) any non-like-kind property received by the taxpayer through the exchange. “Boot” can be cash, debt relief, or using the sales proceeds for closing costs that are not considered valid closing expenses. The rules governing “boot” in exchanges are complex, and an investor may inadvertently receive “boot” and find themselves liable for taxes without expert consultation.
Purchase of the Replacement Property
When selecting the replacement property, the taxpayer has 180 days from the date of the transfer of the property to the buyer to close on the new replacement property. However, the exchange must be completed by the earlier date if the due date for the investor’s tax return for the tax year in which the property was sold falls earlier than the end date of the 180-day period. Since there are no extensions or exceptions to this rule, it is best to schedule the closing for the replacement property before the deadline.
Questions
Frequently Asked Questions (FAQs)
What is a 1031 reverse tax-deferred exchange? A 1031 reverse tax-deferred exchange is essentially the same transaction as a 1031 exchange but is a “reverse” tax-deferred exchange. The second investment property is purchased before the first property is sold.
What is taxable in the tax-deferred exchange? The 1031 tax-deferred exchange strategy only defers taxes. It does not help you avoid them altogether. Everything that is usually taxable is still taxable under the tax-deferred exchange framework. The only difference is that the taxes will not be paid in the year of the sale.
Source: https://www.thebalancemoney.com/how-to-do-1031-exchanges-1798717
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