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1031 Exchange: Some Frequently Asked Questions

1031 Exchange: Some Frequently Asked Questions


Q: What are the possible disadvantages of engaging in a Tax Deferred Exchange?

A: Typically doing a 1031 tax deferred exchange in a limited time frame is the biggest disadvantage. 1031 exchanges are not easy to complete within 180 days, and there is no assurance of it being completed in time. Besides this, it typically creates a possible disadvantage in comparison with the counter party. You must complete a transaction within a short timeframe, and the other party can take advantage. Another typical disadvantage is that the transaction costs are higher for a 1031 exchange than they would be in a simple one-step sale, but given the tremendous tax saving opportunity under Section 1031 most people find the advantage fully justifies the expense to make a 1031 transaction happen.

Q: Do I need to re-invest all the cash that comes from the sale of my Relinquished Property or can I keep some?

A: You can retain some of the cash but you will be taxed on the full amount that you keep. This is called "Taxable Boot" and there are complex regulations on how and when you may receive the funds. If this is not done properly you will disqualify your entire exchange and be taxed on 100% of the gain!

Q: Can I exchange my property for a partial interest in a different property?

A: Yes, if the rules are followed. You can exchange your 100% interest in a property for a fractional interest (e.g. 50%) of another property provided you do not create a partnership.

Q: Can I exchange property between states?

A: Yes. For federal tax purposes you can exchange across state lines without any problems and defer a federal capital gains tax which is presently at a rate of up to 25%. California recognizes 1031 exchanges (no tax due) of California property for property in another state, however, for taxable years beginning on or after January 1, 2014, California Revenue & Taxation Code (R&TC) Sections 18032 and 24953 require California resident and non-resident taxpayers who defer gain on the sale or exchange of California property for out of state replacement property under Internal Revenue Code Section (IRC) 1031 to file an annual information return with the Franchise Tax Board (FTB). Taxpayers are required to file an information return for the taxable year of the exchange and in each subsequent taxable year in which the gain or loss attributable to the exchange has not been recognized. If a taxpayer fails to file the required information return, the FTB can estimate the net income, from any available information, including the amount of gain deferred, and propose to assess the amount of tax, interest, and penalties due. However, each state has different rules. For example, if you are a California resident that owns property in Oregon being exchanged for property in another state, you must pay the Oregon tax. Tax treatment of cross border 1031 exchanges varies with each state and you need to review tax policy for the states in question as part of the decisionmaking process.

Q: Is Real Estate the only asset I can exchange under Section 1031?

A: No. Section 1031 applies to all assets used in trade or business or for investment purposes. Personal property may also be exchanged, but the qualifications for a "like-kind" exchange are more restrictive for personal property. Property that may qualify include boats, farm equipment, trucks and planes.

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