What is a 1031 Exchange Drop and Swap?

The old American saying that “Nothing is certain but death and taxes” is only half true for the taxpayer in this country. Because capital gains tax can reach 30%, why not take the necessary precautions to avoid it and save a significant sum of money for future investments?

1031 Tax Deferred Exchange

For over thirty years, there has been such a provision in U.S. tax law that allows for the deferral of capital gains taxes. It is commonly known as a drop and swap 1031 Tax Exchange and is often referred to as the most powerful tool in the hands of taxpayers. It has always been an indispensable part of the success strategies of the biggest and most famous investors, such as Donald Trump.

Section 1031, the common name in U.S. tax law, allows you to defer your tax liability arising from a capital gain on the sale of real estate or another investment if you use that gain to purchase a similar investment in the future. Capital gains upon the sale of real estate are deferred as long as you follow all tax office guidelines meticulously. It is a wise tax and investment strategy and a great tool when planning for retirement. In theory, an investor can defer or delay paying capital gains tax until death, potentially avoiding it altogether.

Amendments to the 1984 Act

Initially, some parts of the 1031 provision were taken too literally and caused much trouble for people who wanted to take advantage of them. In particular, the stipulation about having to purchase “like” property or investments. However, after the 1984 amendments to the Act, the term “like-kind” investment expanded to benefit taxpayers.

Another significant change was the limitation on the time the exchange/purchase procedure for a new investment takes place.

Qualifications for the 1031 Exchange

Properties that qualify for the 1031 Tax Exchange are investment (rental) properties. Properties that do not allow for the 1031 Tax Exchange are personal and those you purchased for renovation and immediate sale, as well as second and vacation realities that are not intended for rental purposes. However, there is a particular so-called “use test” in Section 280 of the tax law that can apply to second and vacation properties. Therefore, consultation with a tax expert is necessary in this case.

A parcel of land on construction work and property purchased for immediate resale does not qualify for the 1031 Tax Exchange. For a transaction to be prepared, it must possess characteristics of an “exchange” rather than the sale of one property to the purchase of another. You sell the property or purchase it must be an investment or production realty. In other words, they must be “like-kind.”

Here are some examples of properties that meet the “like-kind” condition that qualifies for the 1031 Exchange:

Office building in exchange for a shopping center.

A shopping center in exchange for a parcel of land.

A parcel of land in exchange for an industrial building.

A multi-unit residential building in exchange for an industrial building.

A single-family rental home in exchange for a multi-family rental home.

Time Frame

Currently, you can do many of the investment property exchange combinations listed above. However, there are strictly controlled time frames in which you must do the entire operation. Before 1984, both transactions — the sale of the current property and the purchase of the following property — coincided. Naturally, this created severe difficulties with the transfer of deeds and also with the transfer of funds. Anyone who has ever sold and bought property simultaneously knows what we are talking about here.

An amendment to the 1984 Act makes it possible to avoid this problem. A person who wants to use the 1031 Tax Exchange puts his property up for sale in the usual way. When a buyer comes along, the seller and buyer enter into a purchase/sale agreement with an additional person called a “Qualified Intermediary.” They become a sort of substitute seller.

The closing takes place, and the intermediary immediately takes over all funds. The seller has no access to the funds. At this point, a time restriction called the “45-Day Rule for Identification” begins. The seller must identify potential properties they wish to purchase during this period. This 45-day period is non-negotiable, and the IRS does not consider any exceptions or relief circumstances.

In selecting potential properties, you should follow the following rules:

You may choose three properties regardless of their market value or any number of properties as long as their combined market value does not exceed 200% of the total market value of the property sold.

Suppose the number of properties is exceeded or the 200% rule is exceeded. In that case, you can still take advantage of the 1031 Tax Exchange if the seller purchases 95% of the total market value of all of the designated properties.

What is a Boot?

Most often, most investors choose the Three Properties option explained above to fulfill all the requirements imposed by the IRS when typing up potential candidates for new investment. Out of these three, they choose the one that best suits them physically and financially. If we talk about financial considerations, the ultimate goal is to avoid the so-called boot.

The “boot” is the extra money or any other additional form of value that the seller receives after the tax exchange. In other words, it is the excess or leftover money left over after the entire transaction has taken place. These benefits do not meet the “like-kind” condition as explained by the IRS. The rules for how you should treat boots are very complicated. You should enlist the help of someone proficient in the subject to avoid the tax imposed on this excess.

The Rule of 180 Days

Once the investor has chosen the property he wants to buy, he has 180 days to complete the transaction (closing). It has to be 180 from the time of the sale of the previous property.

There is a significant thing to know: if the deadline for filing the tax return for the year in which the tax exchange took place, including all deferrals, falls on an earlier date than the 180-day deadline, then the deadline for completing the purchase is the earlier date. There are no concessionary circumstances that would allow you to extend this deadline. So we advise you to consult with a competent real estate agent who can help you coordinate the entire endeavor.

“Do it yourself?” No!

Depending on the individual taxpayer’s situation, other aspects of the exchange may apply. It isn’t straightforward to carry out the entire operation, and the help of competent professionals is indispensable. These professionals include a real estate agent, someone proficient in mortgage lending, a certified public accountant, a tax advisor, and an attorney.

By taking advantage of the 1031 Tax Exchange, we can multiply our capital resources and increase our wealth. We can improve our financial cash flow and diversify our investments. Everyone has this right in this country, and this is the way to avoid tax.