Top 5 FAQ about 1031 Exchanges

What is “Boot”?

When conducting a property exchange, it is possible to transfer non-like-kind property or money in addition to the exchanged property, and this is referred to as “boot.” Generally, the tax liability for boot is only applicable to the realized gain.

It is crucial to structure boot transactions carefully to avoid invalidating the qualifying portion of the exchange. If you receive non-like-kind property or money, the realized gain will be recognized up to the fair market value of the property received and the sum of money. Properly structured exchanges are designed to minimize or eliminate boot.

What is “Constructive Receipt”?

In an exchange, “Constructive Receipt” occurs when a taxpayer has unrestricted access to cash or boot, even if they choose not to exercise that right and without physical receipt of the cash or boot. If you receive cash or boot during an exchange, it will be considered taxable income and will result in the recognition of gain.

If the buyer takes title to your relinquished property without an exchange being opened, the transaction will be considered taxable by the IRS. Therefore, it’s crucial to open your exchange before the close of escrow.

What is “Like-kind”?

In a 1031 exchange, “like-kind” describes the nature or character of the property being exchanged, not its grade or quality. For instance, personal property and real property are not like-kind since they have different natures and characters. In contrast, improved property and vacant land are like-kind because they only differ in grade or quality.

You can exchange raw land, condominiums, single family residences, shopping centers, apartment buildings, farm and ranch land, commercial real estate, industrial property, second homes converted to investment property, and almost all other types of real estate with each other, as they are of like-kind in terms of their intrinsic nature and character. There are some exceptions, but in general, if the real estate meets the tests described above, it can be exchanged for any other type of real estate.

Furthermore, it’s important to note that just because the identification requirements allow for the inclusion of incidental property, it does not mean that such property will be considered like-kind real estate. It’s essential to remember that the final regulations for “Multi-Asset/Personal Property” exchanges provide for a very limited qualification of any non-realty business or investment property that can be transferred together with real estate. This means that items such as furniture, manufacturing or other equipment, automobiles, or artwork, etc. transferred in addition to real estate are not considered like-kind property to real estate received as replacement property.

Each state in the United States determines the definition of realty. If you are considering an exchange, it is important to determine the definition of realty in the state or states where the relinquished and replacement properties are located.

Can I exchange my partnership interest in Real Estate?

No, there are extremely limited exceptions. The Internal Revenue Code was amended in 1984 to specifically prohibit the exchange of partnership interests, with the exclusion clarifying that a partnership interest, whether general or limited, cannot be exchanged for an interest in real property without recognizing a gain. Some have attempted to legally circumvent the restrictions against exchanging partnership interests using highly technical and relatively complex structures. Skilled legal and/or accounting counsel must be engaged for such transactions.

What kind of Real Estate qualifies for a 1031 Exchange?

Real property that is of “like-kind” generally qualifies for a 1031 exchange, provided it is not condemned property (which would require a 1033 exchange) or your personal residence (which would require a 1034 exchange), and was not acquired for resale or considered inventory or dealer property. The property you give up in the exchange must have been productively used in your trade or business, or held for investment, in other words, a “qualified use” of the property must have been made. Similarly, when acquiring the replacement property, it must be your intention to either hold that property for investment or use it for a business purpose.

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