After a tsunami of a year facilitating 1031 Exchange transactions, we found there are many misconceptions among investors about 1031 Exchanges. Here are five of the most common areas of investor confusion:
Reverse Exchanges Are Quick & Simple: Identifying replacement property in a hot market was a challenge for 1031 Exchangers this past year, causing many sellers to pursue a strategy of purchasing a replacement property before selling their relinquished property. Known as the Reverse Exchange, in this scenario, the investor first buys a new property of equal or greater value than the relinquished property and then has 180 days to sell their relinquished property. With a Reverse Exchange, you cannot own your replacement property and relinquished property at the same time, requiring an affiliated entity (a Qualified Intermediary) to hold the title of the relinquished property or the new replacement property. While Reverse Exchanges can benefit sellers in hot markets, they take longer to arrange, include more steps, and have, additional costs and fees compared to the more common Delayed Exchange.
Vacation Homes/Secondary Homes Qualify For An Exchange: Residential property can only be considered “like-kind” if held for investment purposes. The rules are very specific. You can sell your vacation/secondary home through a 1031 Exchange if you rented it for more than 14 days per year and your personal use was no more than 14 days per year (and less than 10% of the total nights rented over the two years leading up to the sale). When renting a vacation home you purchased as part of a 1031 Exchange, you must charge rates at fair market value. You cannot rent to a “family member” for $1.00 per night!
1031 Exchanges Are A “Tax Loophole”: Since 1921, 1031 Exchanges have been a vital part of U.S. tax policy. Exchanges have been available in their current form since 1986. Like-kind exchanges encourage capital investment for the highest and best use of real estate, thus improving communities and increasing the local and state tax base. Section 1031 like-kind exchanges encourage capital investment for the highest and best use of real estate, thus improving communities and increasing the local and state tax base. Section 1031 Like-kind Exchanges give businesses and entrepreneurs more incentive and ability to make real estate and capital investments. Far from being a tax loophole, the 1031 Exchange, which has enjoyed political support from Republican and Democrat legislators for decades, is a powerful economic tool that allows investors to grow and transfer their wealth to future generations in the most tax-efficient manner.
Partners In An LLC Can Simply Separate In The Middle Of An Exchange: The “Drop & Swap” alternative is an exit strategy for the sale of real property held in an LLC where two or more partners in the LLC have differing ideas about what to do with the proceeds of their sale. A “Drop & Swap” can allow partners desiring to reinvest their proceeds in another property and continue deferring taxes to “drop” the partnership interests in the LLC and “swap” for Tenant-in-Common (TIC) interests. But the “Drop & Swap” strategy is not simple, and careful planning is required. It is recommended to prepare the property being sold for separate exits before signing a listing agreement with a real estate brokerage.
Considering Replacement Property Options Can Wait Until Closing Of The Relinquished Property: You’ve heard the adage, “timing is everything”, and that certainly holds true regarding the timeline requirements of a 1031 Exchange. Many first-time exchangers, aware of the 45-Day replacement property identification rule, often wait too long to explore their options, only to discover their deadline passes before selecting a property. And their exchange fails. That’s why it’s critical that you work closely with your exchange investment professional and qualified Intermediary to ensure you take the necessary actions at each stage so that your exchange is successful.