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How a 1031 Works
- All monies to be exchanged must be deposited with a non-interested third party called a Qualified Intermediary (QI) or exchange accommodator. The key words here are non-interested, the QI cannot be your best friend or your lawyer or your accountant. In order to avoid any conflict with the IRS a non-partial unbiased unrelated third party should be retained. The typical intermediary fee for an exchange is $5-$10,000 or more depending on the complicity of the transaction.
- The QI can facilitate many different types of exchanges:
- Build to suit / Improvement- the QI holds title to the replacement property on behalf of the property seller, while improvements are done to the replacement property. Commonly known as an Improvement exchange.
- Delayed- In a delayed exchange, typically known as a Starker exchange your relinquished property (your old property) is exchanged for a promise from someone (most likely a facilitator company) to acquire a replacement property for you at a later date.
- Reverse- an exchange where you buy the replacement property first and then you sell your relinquished property (your old property) afterwards.
- Simultaneous- the sale of the relinquished property (your old property) and the purchase of the identified replacement property takes places simultaneously.
- 1033 tax deferred exchange- a special exchange exists when eminent domain( the legal right of the government to seize your property for just compensation) is involved in the sale of your relinquished property (your old property). You have up to 2 years to find a suitable replacement property in this exchange.
- 45 day Identification Period– the investor has 45 days from the closing of the property to select and identify property or properties to purchase and 180 total days to close the purchase of the identified property /properties. Since this is a real estate transaction, this selection process has to be in writing (Statue of Fraud). The Old Man said remember weekends and holidays count so in actuality this identification time period can be much sooner depending on the time of year you do the exchange. Fair warning the old man said, you should protect your best interests and identify more than one property for your exchange , just in case your deal for the replacement property falls through. By code you can identify up to three properties regardless of value and you don’t have to buy all three.
- Like Kind– the property/ properties that you exchange must be of “like kind”. Like kind is real estate or other tangible property that is similar in nature or classification.
Example: Can you exchange raw land for a 10 unit apt building? Yes you can they are both classified as real estate and therefore are of “like kind”. Like kind property cannot be a primary residence or a second home it must be for business or investment purposes
- “Boot”– any non-qualifying property (property that is not “like kind”) received from a 1031 Exchange.
“Cash boot” and “Mortgage boot” are the most common types of “boot”. “Boot” is fully taxable.
For example, you exchange your $500,000 rental property for a $470,000 rental plus $30,000 cash. The $30,000 would be “cash boot” and subject to taxation
The 1031 Tax Deferred Exchange has been a part of the IRS tax code since the roaring 20’s; the very beginning of income taxes in America. The 1031 applies only to property held for commercial, business or investment purposes, a landlord’s primary residence is ineligible.