Navigating the 1031 Exchange Minefield

Doing a Section 1031 exchange transaction may be one way to help process your property as you swap it for another. This is especially true when you're dealing in real estate or other large tangible assets. However, doing a 1031 carries a lot of potential dangers, to the point that it can blow your finances out of the water if you're not careful. Here are some tips to avoid that.

As 1031 exchanges mostly deal on like-kind property, this is often misinterpreted as a tit-for-tat thing; some experts say that like-kind property deals with its intended purpose instead of type, such as a rental house for a tract of land. It is important for a taxpayer to familiarize with all of the key regulations during the structuring of the exchange.

If you've relinquished your property, you only have 45 days to find a replacement property, but do not wait until the last few days to start looking. Time is of the essence because you cannot mark a replacement property when the window has closed. If you do decide to sell a property and closed the deal, forget about a sudden change of plans to do a 1031 exchange.

These are only a few dangers you can prevent at the early stage of a 1031 exchange. A credible 1031 specialist can help you get all your bases covered.

What Should and Shouldn’t be Done in Real Estate Exchanges

Disposal and acquisition of property under the 1031 Exchange section of the Internal Revenue code can be complicated, but it is more lucrative than other real estate investments. Under this section, a property can be swapped for another if they are like-kind or of the same types (i.e. business-for-business like an office for a shopping center). What makes this deal sweet is its virtual exemption from capital gains taxes. For prospective investors in this profitable business undertaking, the following dos and don’ts apply as in any other venture:

Do hire a certified public accountant, real estate agent, or any financial expert that has not seen your books in the last two years. The Internal Revenue Service publication 544 disqualifies monetary professionals who have worked on your behalf from handling property trades.

Do be mindful of the time element. A 1031 exchange has 180 days to be completed, with 45 days to spend in identifying a suitable property. Remember that there are no extensions for these transactions, and that holidays and weekends are included in the six-month period allotted to close the deal.

Do not trade in a property that has lesser value than the one you’re looking at. In such cases, capital gains taxes will kick in (any excess money from the exchange is taxable).

Things to Consider when Planning to Exchange Property Under Section 1031

There are several important things that one should keep in mind when taking advantage of the tax-deferred 1031 property exchange. First, it should be clear that under Section 1031, the provision is only applicable to properties that are in use for investment and business purposes only. This means that one's residence cannot be swapped for a new dwelling.

When it comes to vacation homes and other secondary types of residences, the drawing line is less clear. 1031 may be utilized in these exchanges, although rules set by Congress since 2004 had tightened restrictions on this matter, especially if one decides to re-purpose the new property into a house for rent. For specifics, consult an industry professional.

The provision states that exchanges must be of the same type, but it doesn't have to be the exact same type when it comes to real property. A piece of real estate, for example, can be exchanged with another type of property, whether it's an empty lot or an apartment unit. This does not extend to personal property, where rules are stricter. A car cannot be exchanged with a truck, for example.

Furthermore, several types of what can be ascribed to being a property, are not eligible for exchange under the 1031 provision. This include inventory or stocks in trade, bonds, notes, securities and debt. Likewise, partnership interests or certificates of trust are not exchangeable under 1031.

On Business and Equivalent Exchange

For as long as Man has roamed the earth and put value on different objects, people have always made deals under the concept of fair trade. Even back in the days when money was yet to be invented, people bartered their food, belongings, and services looking to get something at least of equal value in return. This vague concept of “equivalent exchange” is something that has propagated throughout the years, although now it's quite more complex.

In modern times, it's easy enough to believe that money is one of the main, if not the main, movers of societies. Almost all people are born, go to school, and eventually go to work fully accepting of the idea that earning money is the path to survival, comfort, and even happiness. Left and right, people are moving up career ladders and businesses are being built out of the ground, and all of this happens still following certain rules and laws on exchanges and business transactions. There are, decidedly, a whole lot of things you can do with money.

Even money, though, is still a representation of what humans consider to be “valuable”, and exchanges don't necessarily have to involve money—at least directly. In fact, it is possible to exchange entire properties and businesses nowadays, and while these things do involve money at certain points, the exchange itself is not mainly about money. At the root of it all, things just have to be fair because the moment it's not, trouble brews.