The IRS requires you to follow a set of rules to qualify for a 1031 exchange.
Though it isn’t too difficult to execute a 1031 Exchange, particularly if you’ve done it earlier as well, however, you should stick to the following steps in order to carry out the transaction smoothly –
- Hire a Qualified Intermediary and enter into a 1031 Exchange agreement along with him. Not to mention, the participation of a Qualified Intermediary in 1031 Exchanges is mandatory.
- Once you sign the agreement, the Qualified Intermediary will start looking for a buyer for your relinquished property.
- Identify a new asset within 45 days after you receive the price of your old property. This is your ‘identification period.’ You must send a written identification of the replacement property, including the street address, to 1031 Corp on or before the 45th day.
- After identifying the potential replacement property, all you need to do is acquire the same within 135 days. You’ll get 180 days in total for completing your exchange, which starts the day your relinquished property is sold. However, your 1031 Exchange will no longer be valid in case you fail to meet any of the deadlines.
- At last, you’ll have to submit form 8824 to the IRS at the time of filing taxes along with other required documents.
It’s evident that you’ll be able to complete your 1031 Exchange smoothly if you follow the above-mentioned steps. However, another thing that can certainly affect your 1031 Exchange is how you choose your 1031 investment property. As we had mentioned earlier, 1031 Exchanges don’t only provide the benefit of tax deferment but a lot more advantages as well, like diversification, leverage, relief from property management, etc. However, once you’ve completed your 1031 Exchange and deferred capital gains taxes, you can only expect your replacement property to generate more revenue than what your relinquished property was generating. After all, why would anyone exchange their property for another if the replacement property doesn’t generate more revenue than the relinquished one?
Things you should consider while choosing your 1031 investment property?
- Make sure that the Fair Market Value (FMV) of the replacement property is equal to or greater than that of your relinquished property.
- In case the fair market value of the replacement property is less than that of the relinquished property, then that will result in ‘Boot,’ and you will have to pay the taxes on the profit. A Boot can be defined as the ‘cash or profit received by the investor’ in the exchange. Boot eliminates the opportunity of tax deferment.
- Another thing that you should take into account is the running debt on the replacement property. You must acquire a replacement property that has the same debt as your relinquished property.
- The location of your replacement property also plays a vital role. Using a 1031 Exchange, you can acquire a replacement property anywhere in the entire USA. You must look for properties that are built-in developed localities as it will increase the cash flow.
Apart from these, you should also pay attention to things like the property’s age, mortgaged loan on the property, capitalization rate, etc. You should only initiate a 1031 Exchange once you have examined all these aspects.
How to eliminate boot in 1031 exchanges?
1031 exchanges provide unmatched benefits. However, you will lose the opportunity to defer capital gains tax if you don’t reinvest the entire proceeds in a new property. A 1031 exchange is not valid if any cash or money is held by the investors. Therefore, if you are left with some cash at the end of your exchange, you will be taxed on the saved amount. When something is given in addition to a commodity or entity, it’s called boot.
You may end up losing the opportunity to defer taxes if you receive boot any of the following forms –
- Cash – The money saved by the investor at the end of a 1031 Exchange is termed as Cash boot. Say, the value of the old property is greater than the value of the new property. In this case, the difference in both prices is the boot.
- Debt Reduction – When the debt on the new property is less than the loan on the old property, it’s called debt reduction. Make sure that your new property has the same debt as the old one.
- Sale Proceeds – Say for some reasons, you end up using a part of your proceeds on non-qualified expenses like utilities, escrow agent’s feet, and others. In such a situation, you won’t be able to defer your entire capital gains tax.
Avoid things like excess borrowing or utilizing proceeds on other expenses because it can jeopardize your 1031 exchange.
Invest leftover proceeds in DSTs to avoid boot.
You may get confused thinking about how you can invest your leftover proceeds and avoid tax consequences. DSTs can be a great investment option. As DSTs are pre-packaged and easy to close investment deals, you don’t need to wait for a long to close the investment. DST 1031 investments are preferred by investors looking to even out the leftover money when doing a 1031 exchange.
So, what’s our role in your quest for a 1031 investment property? Well, we make sure that a 1031 Exchange expert stays with you throughout a transaction. Our experts can help you get access to 1031 property exchange listings. We also stay in touch with your attorney, accountant, or closing agent to ensure that the transaction carries out smoothly.