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Myths Associated With 1031 Exchanges

by Rishav

If you have ever done a bit of research on 1031 exchanges, you must know that the IRS has strict guidelines for investors. There is a certain set of rules that you must meet to qualify for a 1031 exchange. For example, the property you sell and the property you acquire must be held for use in trade, business, or for investment purposes. But, besides these rules, some myths also circulate among investors regarding 1031 exchanges. For example, you may have read or heard that you can do a 1031 exchange only on investment properties and not on primary residences. Or an investor can’t withdraw cash from 1031 proceeds. However, that’s not often the case. 

The IRS evaluates the intent behind the investment.

The only thing the IRS examines in 1031 exchanges is the investor’s intent. A 1031 exchange or ‘like-kind’ exchange lets investors defer capital gain taxes. However, you must prove your intent to the IRS by purchasing a new property of the same value. Plus, the new property must be used for generating business. That’s why primary residences don’t qualify for 1031 exchanges. But, you can play around the rules and do a 1031 exchange on your primary residence as well.

Just declaring your residence is a rental property won’t work. 

Let’s consider a situation: what if after some time you choose to convert your primary residence into a rental property? Here’s the answer. If you turn your primary home into a rental property (You rent it to a tenant who gets the possession, and you no longer use it as your primary residence), you may be able to do a 1031 exchange on that property.

Although the IRS doesn’t clearly state how long you must hold the property for rental purposes, most tax professionals believe that one to two years should be enough, given you can show the property is used for investment purposes.

The IRS has clear views on the following two points:

  • Just declaring your house is a rental property doesn’t prove it is.
  • You can’t live in your home if it’s a rental property, and you must rent it out for real for some time.

Now, do you understand how to play around the rules? 

Convert your primary residence into a rental property and hold onto it for some time, and you should be good to go for a 1031 exchange. 

How To Save Cash While Doing A 1031 Exchange?

There could be innumerable reasons due to which you need to take out some cash from your 1031 proceeds – a medical emergency, financial crunch, marriage, and vacation are a few to name. But, can you withdraw a part of your proceeds and still qualify for a 1031 exchange? The answer is Yes. A partial 1031 exchange is what you should be doing in such situations.  

Partial 1031 exchange is when you choose to defer a portion of the capital gain tax and not all.

With a partial 1031 exchange, the investor decides to defer a part of capital gain taxes and recognize some gain by either 1) taking out some cash from the proceeds or 2) through debt reduction on their replacement property. Any of these events results in a boot, which refers to ‘anything received in addition to’ the replacement property. A boot can be cash boot or mortgage boot or any personal property received at the end of the exchange.

A boot can occur in different ways –

  • When you ask the closing officer to transfer a part of the sale proceeds directly into your account.
  • After the exchange, if there are properties that have been identified but not purchased, it results in a boot.

Any profit recognized in a 1031 exchange is taxed normally. However, that doesn’t disqualify your exchange. Therefore, if you want to keep some cash from your 1031 proceeds, you can do so, given you’re ready to pay taxes on the saved amount.  

A 1031 exchange is a great investment tool for investors looking to expand their portfolio and increase monthly income. You can swap a non-performing asset with a premium investment property using a 1031 exchange. However, it’s recommended you speak to an advisor or a 1031exchange expert first.

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