Continuing our discussion of Investing in Laguna Beach with a 1031 exchange for investments. Note that there are timing requirements and limitations. (You can read Part 1 here.)
Timing Rules and Delayed Exchanges
Traditionally, an exchange involved a simple swap between two people of one property for another. However, the likelihood of finding a person with the exact property you want who also wants the exact property you have is slim. So, the majority of exchanges become either delayed, three-party, or so-called Starker exchanges.
The term “Starker Loophole” became attached to the law after a 1979 court ruling. The court concluded that an agreement to exchange property within certain time limits constituted essentially the same process as a simultaneous transfer of property. So, in a delayed exchange, a qualified intermediary (middleman) holds the cash after you “sell” your property. The intermediary then uses it to “buy” the replacement property on your behalf. This three-party exchange is treated as a 1031 swap.
There are two key timing rules to observe in a delayed exchange.
The IRS has created two timing rules that must be adhered to for a 1031 exchange.
- 45-Day Rule – The IRS requires the designation of a replacement property. Once the sale of your property takes place, the intermediary receives the cash. You cannot receive the cash or it will negate the 1031 allowance. But, within a 45-day window from the sale of your property, you must designate the replacement property. It must be in writing to your intermediary and specify the property you intend to acquire. However, the IRS says you can designate up to three properties so long as you eventually close on one of them. And, you can even designate more than three if they meet certain valuation tests.
- 180-Day Rule – The second timing rule in a delayed exchange relates to closing. The IRS requires that you close on the new property within 180 days of the sale of the former property.
These two time periods run concurrently. So, you start counting both the 45 and the 180 from when the sale of your property closes. That means, if you designate the replacement property exactly 45 days later, for example, you’ll have only 135 days left to close on it.
Cash Out and Debt Tax Implications
Note the tax considerations if you either have cash remaining from the sale and after the purchase or if you have a reduction in the amount of debt on the new property versus the old.
- Cash (profit): You might have cash left over after the intermediary acquires the replacement property. And, if so, the intermediary pays it to out you at the end of the 180 days. That cash–known as “boot”–gets taxed as partial sales proceeds from the sale of your property. So, the IRS generally considers it a capital gain.
- Debt (mortgage): People primarily get into a mess on 1031 transactions by failing to consider mortgages. So, if you have a loan or other debt on the property you relinquish or any debt on the replacement property, even if you don’t receive the difference as cash, but it reduces your liability, the IRS also treats that as income.
Here’s an example:
Suppose you had a mortgage of $1.5 million on the old property, but your loan on the property you receive in exchange is only $1 million, you have $500,000 of gain. This is classified as “boot,” and it will be taxed.
When you make your exchange, if you intend on avoiding immediate capital gains tax, you’ll need to bear the potential profit of the sale of one to the debt of the other. Your tax professional or financial advisor can help you make the best determination of when an exchange is in your best interest. We can help you find the best property to meet those requirements.
Stay tuned for part 3 in our next post.
If you would like to know more about Laguna Beach investment property or a 1031 exchange, let me know. Finding the best property advisor that fits your needs doesn’t have to be hard. I am commercial-certified and can help investors acquire investment property. And, I have sold several investment properties locally. Let me help you with your 1031 exchange.
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