A properly structured 1031 exchange will defer all taxes normally realized upon sale. Unfortunately, not all exchangers maximize their benefit.
To get the most out of your next 1031, you need to take the appropriate measures.
Now, some of those measures are clear and well-defined.
But other measures aren’t.
Some skill is required to avoid unnecessary tax risk. That means staying away from grey areas.
So think of these as “Best Practices”
Let’s dive in.
Section 1031 says you only defer all of your taxes if you purchase enough replacement property.
But how much exactly?
You must trade equal or up in fair market value compared to what you sold.
Now, these calculations can get complicated. (We’ll avoid too much technical jargon)
There are two basic components:
Net equity is the amount a seller would walk away with at closing (absent a 1031)
It’s distinct from Gross equity. As Mashvisor explains
Net sales price is the full contract price of the property after removing closing costs (commissions, etc.)
Investors that fail to meet either (or both) thresholds must pay taxes on the difference.
Key Takeaway #1:
Use all net proceeds from the relinquished property towards down payment on replacement property.
Key Takeaway #2:
Buy properties worth at least as much as what you sell.
You defer all your taxes.
You can’t change taxpayers during a 1031 exchange.
The initial seller must be the same taxpayer when buying new property.
The IRS allows just one way to report a like-kind exchange:
You must use IRS Form 8824.
Now, every property — relinquished and replacement — must report on the same 8824.
And there’s only one tax ID field.
(No, you can’t list multiple IDs or use two forms).
This can be a bummer.
It means you can’t add or remove taxpayers (i.e. no changes in vesting) during the 1031 process.
Can property held by one spouse exchange for property held by both? (Or vice versa?)
The IRS is not very clear about this.
Under Section 1041, property transfers between spouses are tax-free.
So, can one spouse sell in their individual name… then add the other spouse (under Section 1041) to the replacement property?
Here are two safer options:
Then there are the “community property” states.
In certain states, assets acquired during marriage belong to both spouses.
Gains and losses are shared, too.
Nine states maintain community property laws:
Spouses in these states can title everything jointly.
They can even switch title from one spouse’s individual name to their joint two-member LLC!
This is a BIG subject in tax-deferred exchanges.
“Tax Partnership” can mean either:
– State law partnership
– Multi-member LLC
A lot of investors own real estate this way.
We’ve written about why it is a big hurdle when selling the relinquished property.
Here’s the rub.
Partnerships (intact) qualify for 1031 exchanges.
They can sell and buy together, no problem.
✘ But members can’t exchange separately or change ownership during a 1031.
Always speak with your qualified intermediary before selling as a partnership.
Key Takeaway: Plan ahead. Make sure you sell and buy as the same taxpayer.
We’ve written an in-depth page on avoiding the most common taxable items.
There, you’ll find examples and pro tips.
(1) Buy property(ies) worth at least as much as what you sold
(2) Transfer all net equity into your replacement property(ies)
Don’t take this stuff lightly.
Or you’ll be in for a nasty surprise come tax time.
We hope you enjoyed the read.
Have specific questions?
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