No matter how attractive an investment may appear, as an investor, you must study it before investing. Otherwise, at some point in time during the transaction, you’ll find yourself in a no man’s land, particularly in case of a 1031 Exchange. You may have heard or read somewhere that using a 1031 Exchange, an investor can defer capital gains taxes on exchanging like-kind properties, which otherwise they would be liable to pay. However, that’s not complete knowledge. It’s not even half of what 1031 Exchange investors should know.
Let’s take the example of properties that can be exchanged using 1031 Exchanges. You can’t exchange ‘any’ property and defer taxes taking advantage of this unique investment structure. As per the guidelines, properties involved in 1031 Exchanges must be held for use in trade, business or for investment purposes. In other words, you can only exchange an investment property for another using a 1031 Exchange. However, it doesn’t mean that the relinquished and replacement properties must serve the same purpose. For example, using a 1031 Exchange, you can exchange a retail property for an industrial property or a NNN property and not only for another retail property.
Though some limitations have been imposed on the number of properties that can be acquired as 1031 Exchange replacement properties, however, an investor can identify any number of replacement properties thanks to the following rules:
•The Three Property Rule – As per this rule, an investor can identify up to three replacement properties irrespective of their values, and not all of the identified properties need to be purchased.
•The 200% Rule – Using this rule, an investor can identify any number of replacement properties as long as the combined value of the identified properties doesn’t exceed 200% of the value of the relinquished property.
•95% Rule – As per this rule, an investor can identify any number of replacement properties as long as the value of the property acquired at the end of the exchange is at least 95% of the value of the relinquished property.
Though 1031 Exchanges do guarantee tax deferment, however, 1031 Exchange investors mustn’t take it guaranteed. In other words, you could lose the opportunity of deferring taxes if any gain is recognized at the end of your 1031 Exchange. The term ‘Boot’ is used to define such profits. A Boot can be defined as ‘something given in addition to.' In 1031 Exchanges, a boot is defined as the ‘cash received by the investor.’
Technically, your 1031 Exchange will no longer be valid if you received boot in any of the following ways:
•Cash – Cash boot is defined as the money received by the investor at the end of a 1031 Exchange. For example, if the value of the relinquished property turns out to be greater than that of the replacement property, then it will result in a cash boot.
•Debt Reduction – Consider a case when the debt on the replacement property is less than that on the relinquished property. This kind of boot is known as Debt Reduction.
•Sale Proceeds – In case you end up spending a part of your proceeds from the relinquished property on non-qualified expenses like utility bills, escrow agent’s fee, etc. then it will immediately nullify your chances to defer capital gains taxes.
Excess borrowing can also result in a boot. Therefore, you must only borrow as much as is required.
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