Investors looking to use 1031 exchanges to defer capital gains tax must know that the IRS has strict guidelines for the 1031 tax-deferred exchange. You need to follow the rules established by the IRS to qualify for a 1031 exchange. For example, you must hold both properties (the old one and the one you acquire) for use in trade, business, or investment purposes. Besides, you might have also read or heard that you can do a 1031 exchange only on investment properties but not on primary residences. Or you can’t withdraw cash from 1031 proceeds. However, that’s not often the case.
You must prove your intent to the IRS.
The only thing the IRS examines in 1031 exchanges is the investor’s intent. You are free to use a 1031 exchange to defer capital gain taxes imposed on a real estate sale. However, you must prove your intent to the IRS by purchasing a new property of the same value, and you must use the acquired asset for generating revenue. That’s why primary residences don’t qualify for 1031 exchanges. But, you can play around the rules and do a 1031 exchange on your primary residence as well (we will discuss in the next blog).
You must prove your property as a rental property.
What if there comes a time when you choose to convert your primary residence into a rental property? If you convert your primary home into a rental property by renting it to a third person, you may be able to do a 1031 exchange on that property(check out properties list for 1031 exchange).
There is no specific period mentioned by the IRS for which you must hold the property for rental purposes. However, most tax professionals believe that a year or two should be enough, given you can show the property has been used for investment purposes.
You must keep the following points in mind when doing a 1031 exchange:
- Just declaring your house is a rental property doesn’t prove it is.
- You can’t use your rental property as your residence. Renting out the property is mandatory to qualify for a 1031 exchange.
TIP:Convert your primary residence into a rental property and hold onto it for some time, and you should be good to go for a 1031 exchange.
What happens when you withdraw a part of your 1031 proceeds?
There could be a situation when you need to take out some cash from your 1031 proceeds. A medical emergency, financial crunch, marriage, and vacation are a few to name. But, would not it jeopardize your exchange? The answer is No. You can use some cash from your proceeds and still qualify for a 1031 tax exchange. A partial 1031 exchange is what it will be called.
In a Partial 1031 exchange, you choose to defer a portion of the capital gain tax and not all.
A partial 1031 exchange lets you defer a part of capital gains tax and recognize some gain by either withdrawing some cash from the proceeds or through debt reduction on the replacement property. Any of these events results in a boot, which refers to ‘anything received in addition to’ the replacement property. A boot may result in the form of cash or mortgage or any personal property received at the end of the exchange.
A boot is recognized –
- When you ask the closing officer to transfer a part of the sale proceeds directly into your account.
- When you don’t acquire all identified properties.
Any profit recognized in a 1031 exchange is taxed normally. However, that doesn’t disqualify your exchange. Therefore, if you want to keep some cash from your 1031 proceeds, you can do so, given you’re ready to pay taxes on the saved amount. A 1031 exchange is a complex investment structure. It’s recommended you consult a tax advisor or a 1031 exchange expert before applying.