Common 1031 Misconceptions

In simple terms, a 1031 exchange moves the gain from the sale of an old investment property into the purchase of a new investment property. By moving the gain into a new property, you defer paying tax on that gain into the future.

For example, suppose Jane Doe sells her rental house for $200,000. She bought it five years ago for $150,000. Now using a 1031 exchange, she buys another investment property for $200,000. By following the IRS’s requirements, she is able to transfer all her gain into her new property instead of paying taxes on the sale.

Since the most recent real estate boom, people have become more aware of 1031 exchanges than ever before. Even with this increased awareness, there are still some prevalent misconceptions about this specific section of the tax code. As a 1031 exchange consultant, I hear these misconceptions everyday. Here are the most frequent three I hear:

1) I’m selling a rental house, so now I have to buy a rental house.

This is not true. The IRS uses the term “like-kind,” but for real estate this is very broad. Both your old and new properties only need to qualify as investment or business use. If both properties pass this test, you can exchange nearly any type of real estate for any other kind. In our first example Jane Doe is selling a rental house. Now she can buy an office building, a commercial property, or even bare land. And of course she can always buy another rental house.

2) I’m selling for $200,000; if I buy a property of less value it will invalidate my exchange.

In order to not pay any tax, you must buy equal-or-up. If Jane sells her old property for $200,000 and buys a new property for $190,000, this doesn’t toast her whole exchange. She merely pays tax on the $10,000 buy-down. And the whole $10,000 will be taxable.

3) In order to complete my exchange, I must find someone to swap properties with.

Originally, this was how exchanges were structured. This is not the case anymore. You actually have 45 days from your sale closing to identify your replacement property, and 180 days from your sale closing to close on your new replacement property.

§1031 is an evolving IRS code section; the rules occasionally change, and there are still many misconceptions out there. Real estate investors and professionals need a reliable source to keep up-to-date on the latest developments.

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