1031 Exchange Insider: Your Comprehensive Guide of FAQs

2. What does not qualify for a 1031 Exchange? 

There are several situations where a property would not qualify for a 1031 Exchange, those include:

• Property being used as a primary residence before a sale does not qualify.
• Property held primarily for resale, such as new construction sales, fix and flip sales and developed lot sales, also do not qualify.
• Vacation property will not qualify if the amount of personal use of that vacation property is greater than 10% of the rental use.

3. What does like-kind mean in a 1031 Exchange? Do I have to buy the same type of property I sold?

Any real property held for business or investment is like-kind to any other real property held for business or investment. The characteristics of a specific property do not impact the exchange. For example, an office building, a single-family home, an industrial warehouse or a retail center are all exchangeable with each other, provided they are held for business or investment.

4. What is the benefit of a 1031 Exchange?

The primary benefit seen in a 1031 Exchange is the deferment of capital gains tax, which allows you to avoid immediate tax payments and redeploy all your capital into the new investment.

5. How can I use a 1031 Exchange to benefit my investment strategy?

A 1031 Exchange brings a wealth of benefits to an investment strategy, including:

• It can allow you to cash in your equity gains on a property and re-leverage the gain to buy more properties or a higher-value property.
• Similarly, an exchange can allow you to increase your monthly income by investing in higher cash flow properties versus high-appreciation properties.
• It enables you to relocate your investment properties to a new city or state.
• Lastly, it can reduce your property management workload by investing in low-management property types. 

6. What is the role of a Qualified Intermediary (QI)? 

A QI is critical in a 1031 Exchange. They play many roles throughout the entire exchange process. First, the QI will educate the investor on the requirements to comply with IRS rules and deadlines. Once this happens, the QI will directly engage in the sale closing to ensure exchange funds are properly received by the QI. Once the funds are properly received, they will work with the investor to ensure compliance with property identification rules. If everything abides by the rules, the last thing a QI will do is engage in the purchase closing to deliver the exchange funds necessary for the purchase.

7. What are the time periods and deadlines for a 1031 Exchange? Can a deadline be extended? 

There are two key periods in a 1031 Exchange: the 180-day Exchange Period and the 45-day Identification Period.

• The 180-day Exchange Period starts on the date the investor sells their Relinquished Property and ends at midnight on the 180th day. All identified Replacement Property must be purchased within 180 days.
• The 45-day Identification Period is an internal deadline within the 180-day Exchange Period during which the Taxpayer must identify all potential Replacement Property. It allows the investor to narrow their choices that might be the Replacement Property. After these 45 days, exchange funds can only be applied to purchase the Identified Property. If by chance you have not found any suitable Replacement Property, this can allow you the opportunity to end the exchange early. If you choose not to identify any Replacement Property, the exchange will end on day 45 and your funds will be returned to you.

An investor or QI cannot extend either of these deadlines. However, there could be cases where there is a national extension, such as during COVID-19, or a local extension, such as during extreme weather events.

8. What is a “boot” in a 1031 Exchange? 

“Boot” is an unofficial term referring to anything the investor receives in the transaction other than their replacement property. Boot triggers the taxable gain.

“Cash Boot” refers to any actual cash the investor received during the exchange process. This can occur for one of two reasons. One, they choose to receive some money at the closing of their relinquished property sale or two, they do not spend all exchange funds on the replacement property and receive the remainder at the end of the exchange. In both situations, the investor will receive “Cash Boot” in addition to the replacement property which is taxable.

“Mortgage Boot” is more abstract and refers to when an investor does not replace the value of the debt paid off when they sold their relinquished property. For example, if a relinquished property sells for $600,000 and requires a $200,000 loan payoff at closing, there will be $400,000 of available exchange funds. If the investor then purchases a lower-priced replacement property for $400,000 and only uses the available cash exchange funds, the result is a $200,000 reduction in debt for the investor, which is considered “Mortgage Boot” and will trigger partial taxation. 

9. Do I have to exchange all my funds in a 1031 Exchange?

No, you do not have to exchange all your funds. It is possible to do a partial exchange where some money is sent to the QI to be reinvested in the replacement property and some money is received by the investor. Any money received by the investor is Cash Boot, which is taxable. See question #8 for more details on Cash and Mortgage Boot. If you want to learn more about full tax deferment, check out this video.

10. For a 1031 Exchange, can you buy in one state and sell in another?

Yes, a domestic exchange can occur between property in any of the states.

11. For a 1031 Exchange, can you buy in one country and sell in another?

A foreign exchange can occur with any property outside of the United States, but you cannot exchange a domestic property for a foreign property, or vice versa. 

12. Are there any risks associated with a 1031 Exchange?

A 1031 Exchange does not present a high risk to the investor. However, there are certain scenarios to be mindful of that could result in a failed attempt to complete an exchange. Those scenarios include:

• Not finding suitable property to identify during the 45-day identification period. If the investor is not diligent about locating potential replacement property, they may find themselves quickly approaching the deadline with no viable properties to identify.
• Identifying a to-be-built or new construction property. While this is not prohibited, it is very common for new construction homes to have closing delays, which can push them beyond a 180-day exchange period. The investor must be mindful of this possibility when identifying new construction.

Both of these scenarios and others that may happen are why working with a QI is critical to ensuring all rules and deadlines are followed for a successful 1031 Exchange. 

Have additional questions about 1031 exchanges we didn’t cover? We can answer them! Get in touch with the Ten31 Texas team today.