You may have heard of the IRS 1031 exchanges. The 1031 exchanges can be applied to real estate too, but what exactly does it mean when someone says they are doing a 1031 exchange? Is it about rental property accounting or anything related to capital improvement? Well, let us have a look at it.
The IRS defines an exchange as “a transfer, directly or indirectly, for adequate consideration to a single person in which both parties gain equal economic positions.” This is a key point because it confirms that you cannot do a 1031 without giving up the property you currently own in return for something else of value. It also means that this type of swap should not be used for speculative purposes or risk-taking transactions. That is why anyone with an interest in doing a 1031 exchange should assess the situation and understand the tax risks involved.
The IRS considers a 1031 exchange to be one of the safest and most effective ways for individuals to minimize their tax liabilities. If you are thinking about doing a 1031 exchange then you should also think first before actually doing it. Read on to learn about the risks of a 1031 exchange, what items and businesses can be used as part of the consideration, and how best to conduct this type of transaction.
Risks Of A 1031 Exchange
Exchanges may be more complicated for investors who are planning on using them as a way to minimize permanent gains or losses from other transactions (i.e. selling a property in order to offset gains from a stock sale, etc.).
If you own a business, you will generally have to sell at least 80% of the business in order to qualify for the exchange. If you do not want to sell 80% of your business then you will be considered to have an allocation of less than 1031. This means that there might not be enough profit and loss to offset other income and expenses on your personal tax return. In this scenario, you would have a taxable gain on your personal return upfront which would also be subject to income taxes after the exchange is complete.
If you are planning to use a 1031 exchange for the purpose of ending all of your wealth in one transaction, then you should review your personal tax situation with a professional before proceeding.
You should be aware that there are some unique risks to doing a 1031 exchange because it is more complex than typical asset sales which are marketed as such. For example, if you do not have sufficient assets to pay the taxes on a 1031 exchange or you end up owing extra taxes after the transaction is complete, then your chances of getting in touch with the government prior to paying your taxes and penalties could be very high.
Areas Where You Can Use A 1031 Exchange
1031 exchanges can be applied to a wide range of different properties and businesses including:
Real Estate. This would include an apartment or house that is part of a larger property or real estate development. A condominium unit would also be eligible for a 1031 exchange if the rest of the property qualifies as well. An office building could also be considered although the IRS does not allow you to use the exchange for a rental property. You should only use 1031 if you are selling one piece of land to pay off debt obligations on another piece of land, and these transactions are not considered speculative.
Businesses. This means you can use a 1031 exchange to sell the entire business, individual stocks, shares of stock in a partnership, or other stocks not part of a business. Although the IRS allows you to do this for most types of businesses, there are some restrictions on what types of businesses can be traded this way. You should always consult with an attorney before doing anything that might increase your risk of being audited by the IRS because the rules are different for different types of businesses.
Stocks and Bonds. A wide range of different equities and debt instruments can be traded through this procedure including individual stocks or bonds that have been held within a retirement plan, IRA, or 401(k). You can trade stocks on the stock exchange even if they have been held in a Roth IRA. If the stock is a long-term investment or has been held for more than 12 months then it can be traded using a 1031 exchange. You would also need to pay taxes and penalties if you did not properly report these transactions and the IRS catches you. You would have to add back all of the taxes, capital gains, and dividends from your taxable property regardless of whether or not they could be satisfied through the 1031 exchange.
Businesses With Real Estate Investments. This is called a real estate replacement transaction or “RRE” where you sell an entire business but keep all of its real estate investments (i.e. buildings, factories, land) for capital improvement. You would have to provide all of the receipts and records to prove that you did not receive payments as part of your consideration in order to qualify for this type of arrangement. You could also do an RRE if you were going out of business or retiring from a business where you own multiple pieces of real estate.
The IRS has strict requirements when it comes to doing an RRE with the 1031 exchange program and will require you to provide all of your documents with supporting data including:
- A listing agreement between the seller and buyer for all real estate assets must be dated within 30 days before the transfer date.
- A copy of a sales contract or deed transferring ownership.
- A statement by the seller stating that they have no prior or existing intention to sell any of the real estate assets which will be included in the sale. If this is not true, then you can face stiff penalties when you file your taxes.
- Businesses With Real Estate Investments And Additional Personal Property Investments. This is called a Section 1031 exchange (i.e. “triple-like-kind”) where you sell an entire business but keep all of its real estate investments (i.e. buildings, factories, land). You would have to provide all of the receipts and records to prove that you did not receive payments as part of your consideration in order to qualify for this type of arrangement. You could also do a 1031 exchange if you were going out of business or retiring from a business where you own multiple pieces of real estate.
You can use the 1031 exchange on most types of businesses, including:
Restaurants. This is usually done with restaurants where there is a restaurant used for more than six months per year and you are going out of business. Other reasons include retirement, going out of business, or closing the business due to poor sales because the IRS will allow it under these circumstances.
Doctors’ Offices. This is usually done with doctors’ offices where there is a doctors’ office used for more than six months per year and you are going out of business. Other reasons include retirement, going out of business, or closing the business due to poor sales because the IRS will allow it under these circumstances.
Retail Stores and Service Businesses. This is usually done with retail stores and service businesses where there is a store or service business used for more than six months per year and you are going out of business. Other reasons include retirement, going out of business, or closing the business due to poor sales because the IRS will allow it under these circumstances.
Rental Properties. This is usually done with rental properties where there is a rental property used for more than six months per year and you are going out of business. Other reasons include retirement, going out of business, or closing the business due to poor sales because the IRS will allow it under these circumstances.
Builders And Developers. This is usually done with builders and developers where there was a residential building or apartment complex that was used for more than six months per year and you are going out of business. Other reasons include retirement, going out of business, or closing the business due to poor sales because the IRS will allow it under these circumstances.
Non-profit Organizations. This is usually done with non-profit organizations where there is a non-profit organization used for more than six months per year and you are going out of business. Other reasons include retirement, going out of business, or closing the business due to poor sales because the IRS will allow it under these circumstances.
Churches and Religious Organizations. This is usually done with churches and religious organizations where there is a church or religious organization used for more than six months per year and you are going out of business. Other reasons include retirement, going out of business, or closing the business due to poor sales because the IRS allows it under these circumstances. Social Security Administration. If you are a person with a disability for whom the SSA pays benefits and you will be gone for more than six months because of going back to work or going back to college or vocational school, then you can request a waiver.
Employer Requesting Changed Residence Due to Change in Work Hours for an Employee. This is done when your employer requests that you move so that they can meet their work hours and needs.
The 1031 tax code does not allow for a swap between business partners, family members, or partnerships. One person cannot buy a business with another person as part of the consideration unless that other person is a corporation and has done an S corporation 1031 exchange. However, if you want to trade your home and personal property with real estate professionals, you can do so through a Power of Attorney transaction. This is all about the IRS defining a 1031 exchange. Though if you need any help with rental property accounting, you can consider making use of the property management app and get the best help from Better Capital for the same.
