A 1031 Exchange is the nickname used in reference to Section 1031 of the U.S Internal Revenue Service Code. It allows a real estate investor to sell a property and reinvest the proceeds in new investment without paying capital gains.
There are some conditions that you must meet before you can do a 1031 Exchange in New Jersey. The following is everything you need to know in this regard:
The Properties in the Exchange Must be Used for Business or Investment Purposes
According to Section 1031 of the Internal Revenue Code, properties in an exchange must be “like-kind.” In other words, the two properties must have the same nature and character. However, they need not share the same quality or grade to qualify.
The following are examples of exchanges that would qualify under a 1031 Exchange:
- Exchanging raw land for an apartment
- Exchanging a single-family property for a multi-family unit complex
- Oil and gas royalties for a ranch
- Raw land or farmland for improved real estate
- Retail, industrial, commercial or residential rental properties for any other real estate
Such properties are of the same nature and character and you can exchange them without incurring a tax liability. However, the same cannot be said of the following properties:
- Personal or private residence
- Flip-and-fix properties as they are considered to be purchased for resale purposes
- Bonds and stocks
- Properties located outside the U.S
The Exchange Must be Carried-out by a Qualified Intermediary
Who exactly is a qualified intermediary? A qualified intermediary is a person or company whose role is to facilitate a 1031 Exchange. The intermediary can be a CPA, an employee, an attorney, an investment broker, or a real estate agent.
The intermediary is allowed to sell the property on the behalf of the taxpayer, keep the funds, and then use those funds to buy a replacement property. The role of the Qualified Intermediary is key to completing a successful exchange.
You Must Trade-Up not Down
The value of the replacement property must be higher than that of the relinquished property. Otherwise, if the replacement value is of lesser value, then you risk having “boot”. And boot is taxable, which would defeat the goal of carrying out a 1031 Exchange.
The following are other ways in which “boot” occurs in a 1031 Exchange:
- Mortgage Reduction - This can occur in either of two ways. One, it can occur when the debt on relinquished property is higher than the debt on the replacement property. Or two, if the mortgage on relinquished property is less than the mortgage on the replacement property.
- Personal Property - Boot can also be created through personal property, such as furnishings, appliances, equipment, and supplies. These are personal property rather than real property.
- Non-like-kind Property - Including a non-like-kind property will also create boot in a 1031 Exchange.
- Non-transaction Costs - Taxable boot can also arise when sale proceeds from a 1031 Exchange are used to service non-closing expenses or transaction costs.
You Must Abide by Important Exchange Timelines
Before 1984, virtually all exchanges occurred simultaneously. In other words, closing on the replacement property and transfer of the relinquished property were done at the same time.
However, the simultaneous transfer of funds and titles led to a multitude of problems. To avoid them, purchase deadlines were imposed by the Internal Revenue Service. The new deadlines required the potential replacement property to be identified within a 45-day window and the entire swap completed within a 180-day window.
45-Day Rule
This is the first restriction in a 1031 Exchange. As an investor, you must either close on or identify in writing a potential replacement property within 45 days after closing on and transferring the relinquished property.
A relinquished property is one that a taxpayer is selling in a 1031 Exchange. The proceeds of such sale are kept by a Qualified Intermediary. The 45-day period is non-negotiable and includes both holidays and weekends. If for whatever reason, you exceed the time limit, the exchange may be disqualified. Consequently, the exchange will be subjected to capital gains tax.
You aren’t capped at just choosing one replacement property. You have two options in this regard. You can identify up to three like-kind properties regardless of their fair market value, or you can select a large number of properties as long as their aggregate fair market value doesn’t exceed 200% of the aggregate fair market value of the relinquished property.
180-Day Rule
After choosing the replacement property, you’ll have 180 days to close on it. The deadline starts from the date you transferred the relinquished property. And again, just like the 45-day rule, this purchase deadline cannot be extended.
Types of 1031 Exchanges
There are four types of 1031 Exchanges and they are as follows:
- Delayed Exchange - This is the most common type of exchange that investors use today. The exchange occurs when a property is first relinquished and then swapped by a replacement property.
- Reverse Exchange - This is the opposite of a Delayed Exchange. This requires that you acquire the replacement property before exchanging the property you already own.
- Simultaneous Exchange - This is when both the replacement property and the relinquished property are exchanged at the same time.
- Improvement or Construction Exchange - This allows a property owner to use tax-deferred dollars to improve or update a replacement property held by a Qualified Intermediary.
All these types of 1031 Exchanges have rules that an investor must follow for the exchange to be successful.
Bottom Line
There you have it – everything you need to know to carry out a successful 1031 Exchange in New Jersey. If you need expert help, contact the experts at Lone Eagle Management. We have years of experience in property management in New Jersey and can help investors gain peace of mind while maximizing their ROI.