Section 1031 of the Internal Revenue Service (IRS) Code allows exchangers of real estate properties to defer any tax obligation as a consequence of the sale. Gleaning from experts in 1031 exchange services such as 1031 Exchange Place, this type of transaction was popularized by the 1979 court decision in the case of Starker vs. the United States. The U.S. Court of Appeals allowed T.J. Tucker and his son and daughter-in-law to swap 1,843 acres of timberland for new land without paying capital gains tax upfront.
This court decision was a game changer because like-kind exchanges back then were thought to be done simultaneously. The Starkers and their timberland buyer, Crown Zellerbach Corporation, agreed to complete the deal in five years.
Although critical changes have been made to the IRS Code to address the loophole since then, many property owners still employ 1031 exchanges. However, there’s no denying that average Americans don’t know how exactly the process works. With that in mind, it pays to debunk these common misconceptions before attempting to defer tax through this measure:
You Can Use Your Primary Residence
A 1031 exchange is only a tax deferral when real estate properties held for business and investment purposes are involved. This means that you can’t exercise it when selling the house you’re living in and buying the other you’re planning to move into.
Apart from owner-occupied residential properties, the rules of a 1031 exchange don’t apply to timeshares. Timeshares are generally used for personal enjoyment, so they can’t be used to avoid tax.
Moreover, doing a 1031 exchange for a vacation house is usually trickier than thought. If you can’t prove that you’re renting the property out for a certain period, the IRS might not allow the execution of this measure.
You Can Use a Property Overseas
American taxpayers can’t benefit from a 1031 exchange when selling a piece of real estate located in another country. If you have a beach resort in Costa Rica or a restaurant in Singapore, this tax-deferred measure is off the table.
You Must Buy a Similar Type of Property
“Like-kind” shouldn’t be interpreted strictly. You can use any qualifying form of real estate to execute a 1031 exchange. For instance, you can sell an apple orchard and use the sale proceeds to buy a hotel without paying capital gains tax upfront.
You Can Wait Forever to Search for a Property to Buy
Unlike the original case that involved a five-year agreement between the Starkers and Crown, new 1031 exchanges must be completed within six months. After selling your property, you only have 45 days to find a like-kind property that should be of equal or greater value. Then, you should acquire the property within 135 days after the initial 45-day period ends.
A properly structured 1031 exchange is an effective way to avoid tax legally for an undetermined period. In some cases, the heir of a qualified property left by a deceased person cannot be held liable for capital gains after the sale of real estate. The key is to work with a qualified 1031 exchange expert to employ this measure flawlessly.