Even though 1031 exchanges have been a part of tax law since 1921 and that most people have heard of or know something about them, there appear to be a lot of misconceptions in the marketplace about what they are and how they work. Today we will debunk several myths. Is it reality or fallacy?
Myth #1: When it comes to real estate investments 1031 Exchange ALWAYS makes sense?
FALSE, let me tell you why:
1. Why would you defer taxes if you’re in a lower tax bracket one year? Right? If you’re in a lower tax bracket the year you sell your investment, just pay the taxes at that lower rate than you would later knowing you’re going to be in a higher tax bracket in the future.
2. If there is no gain on the investment property the 1031 exchange serves no purpose.
3. If someone is in the 10% -12% ordinary income tax bracket, they would not need to do a 1031 exchange because, in that case, they will be taxed at 0% on capital gains
4. If you want to re-invest into something other than real estate, you may want to pay the taxes to have the cash to invest something else
Myth #2: 1031 is only for commercial properties.
FALSE: Although it certainly includes commercial properties, it also extends to rentals and to land held for investment. While a high percentage of commercial transactions have 1031 as a component most investment properties are residential rentals including single family and duplex properties.
Myth #3: To do an exchange the replacement property has to be equal price or higher!
False: Actually, you can buy a lower price investment property if the total of the purchase price and the net closing costs are of equal value. So, if you sell a property for $1,000,000 and your closing costs were $25,000 your replacement property can be $975,000. Also, if your replacement property is worth less than your net purchase price plus closing costs, you can still do a 1031 exchange and just pay tax to the extent of the shortfall. So, in essence if the replacement property was only $950,000 you can still conduct the exchange and simply pay capital gains tax on $25,000 shortfall.
Myth #4: If you are doing an exchange and selling a rental you must buy a rental!
False: Perhaps the second-best feature of a 1031 (after the tax deferral) is the generous definition of what it means to be “like kind” real estate. All real estate is like kind if what is being sold is held for investment or for productive use in a trade or business and what is being purchased will be held for investment or for productive use in a trade or business. So, the Taxpayer can sell a rental and buy a commercial building – like kind! The Taxpayer can sell a commercial building and buy multiple bank-owned single-family houses as rentals! The Taxpayer can sell land and buy a building to house their business! The combinations are limitless.
Myth #5: – You must sell your investment property before you can buy the replacement property
False: In fact, you can buy your replacement property first, specifically within 180 days of selling your current investment and still qualify for the 1031 exchange, except now it’s called a “reverse exchange”
Myth #6: You cannot do a 1031 exchange on your own or even using the escrow company. It requires a qualified intermediary.
True: A qualified intermediary (QI) must facilitate a 1031 exchange and their main role is to hold funds from the relinquished property and uses them to acquire the new replacement property. These funds never come into contact with the property owner, who is involved in the 1031, per the IRS 1031 rules. Once you touch the money its taxable so make sure you do it right.
If you’re interested in pursuing real estate investments and looking at the option of real estate investing in the near future, please reach out to us.
