Three 1031 Exchange Myths

Over the years while speaking at seminars and in phone consults, three common 1031 exchange myths appear. Prior to getting to the three myths, let’s cover “what is a 1031 exchange?”

1031 Exchange

A 1031 exchange allows the seller of a rental property to sell and defer the capital gains and recaptured depreciation taxes as long as any type of real property such as land, oil and gas royalties, or commercial property are acquired of equal or greater value. Tangible and intangible personal property such as livestock, aircraft and patents are also eligible for 1031 tax deferral treatment.

The tax obligation does not evaporate, but rather delayed, postponed until the replacement property is sold. The tax can represents up to 40% of the old property’s sale price. Why not use those dollars towards purchasing the replacement property?

1031 Exchange Myths

The top three exchange myths are:

  • land must be exchange for land or rental for rental property.

As with all 1031 exchanges, consideration must be given to the nature and character of conveyed rights of the 1031 exchange properties to determine whether they are essentially alike. This includes the likeness of physical properties, character of title conveyed, rights of the parties and period or duration of interests. Real property can be exchanged for any real property.

  • Earnest money deposit can be returned at propert closing tax free.

The IRS views the first dollar out as taxable. Yes, that means being taxed twice.

  • Replacing retired debt from first closing is not required.

Many assume only the net equity from the sale needs to be reinvested. If the old property has debt, then that debt must be replaced in the replacement property, unless additional cash takes its place. Cash offsets debt, but debt does not offset cash. If the debt is not replaced, a tax is triggered called mortgage boot or a benefit of no longer having the debt.

Conclusion

There are many 1031 exchange rules. Engage a qualified intermediary that will ask the appropriate questions to help make sure you are aware of your responsibilities.

Do you have a question regarding a 1031 exchange? I always suggest to engage the qualified intermediary when you are considering placing the property up for sale. Experience matters.