1. Defer Income Tax.
When selling your property, federal and state taxes can be owed on your profit. The IRS has capital gains taxes, depreciation recapture taxes, and a Medicare Tax. Most states also charge capital gains taxes.
2. Defer Depreciation Recapture Tax (25%).
On the depreciation taken on a property, the IRS charges a Recapture Capital Gains Tax at a rate of 25%. This tax is a federal tax. By using a 1031 Exchange, this tax can be deferred.
3. Understand Time Requirements of 45 Days and 180 Days.
Using a 1031 tax deferred exchange, certain date requirements must be met. After closing on a sale, the exchangor has 45 days to identify their exchange property(ies). This date is a hard date. If you do not identify by this date, then your exchange falls apart. You also have 180 days to close the purchase(s) of your exchange property. This date is set from the closing of your sale. Some people think it starts when you identify, which is not the case. Also, an exception to the 180-day period exists. The closing has to take place by the time you file the tax return for the year in which you sold the property. If you close in late December, your exchange could fall apart if you do not close your purchase by the time you file your tax return. If you have an open exchange, do not file your taxes early, and if you need to, extend your tax filing deadline, within the 180 day time-frame.
4. Purchase Price needs to be equal to or higher than the sales price to avoid "boot".
The purchase price of your exchange property has to be equal to or higher than your sold property's sale price, after closing costs are deducted. If not, then you receive "boot" for the difference. You would be obligated for taxes on this "boot". The IRS considers "boot" to be profit. For example, if you have a $100,000 profit, and take $50,000 in "boot", you would be taxed on the full $50,000 as profit.
5. All Equity (cash) must be reinvested to avoid "boot".
All cash coming out of your sale must be re-invested in your new purchase(s). Any remaining cash is considered "boot". If you receive "boot", you could be obligated to pay taxes on that portion of your gain.
6. Avoid Mortgage "boot".
When you purchase your new property, you will need to encumber the same or more debt. If your new mortgage is smaller than your old mortgage, the IRS would consider this receiving "boot". An exception exists if you replace your mortgage "boot" with additional cash. If you receive "boot", you could be obligated to pay taxes on that portion of your gain.
7. Buy and sell "like kind" property.
When choosing your new property, you want to choose "like kind" property. Your new property will be considered if it will be used for business or investment purposed. Property bought to flip is not eligible for 1031 tax treatment. Some personal use property could potentially be exchanged. If a personal residence has multiple units, a partial 1031 exchange could be done for the investment side. Also, if a personal residence was used for investment purposes, but was used as a personal residence for 2 of the preceding 5 years, a partial 1031 exchange could be used, in addition to using an IRS S 121 personal sale exemption. "Like Kind" refers to investment and business use, so a multi-family property could be exchanged for an Industrial building or land, for example.
8. Work with a competent 1031 Exchange Qualified Intermediary.
A competent 1031 Qualified Intermediary (QI) will provide you with proper documentation going through the exchange process. The 45-day and 180-day time frames are hard dates, so you want to make sure your QI keeps your paperwork straight. When using a 1031 exchange, proper contract language is important. Adding proper clauses to your contract will make sure your seller works with you to complete the exchange.
9. Review Financing to make sure the proposed exchange property is a good fit.
Our financing partner reviews the full financing package attached to the exchange property(ies). With the tight time constraints in a 1031 exchange, quickly understanding the due diligence of your replacement property is paramount. Examples of important due diligence items include 3rd party report reviews and reviewing Profit & Loss Statements, leases, rent rolls, and expenses, etc.