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Two Basic Misconceptions of 1031 Exchanges

If you are in the process of selling real estate for a profit—whether you are an investment professional or not—your goal is to most likely defer your taxes.  If so, it's a safe bet that you've heard of the term “1031 exchange”.
There is plenty of information floating around that makes it possible for the novice to perform the 1031 exchange steps –
  1. Hire a qualified intermediary (QI).
  2.  Ensure that the QI holds sales proceeds in escrow.
  3.  Ensure that the QI releases the escrow for use in purchasing a “replacement” property.
  4. Ensure that the QI informs you about critical deadlines for identifying new property and latest closing dates for purchasing replacement property.
Although the administrative side is important, there is also a tax side to this story.  To understand how 1031's work from a tax perspective, below are two classic misconceptions that many novices believe:

MISCONCEPTION 1:  Replacing the original property with another property at the same original cost.
If you sold your property for $1 million and it originally cost you $300,000, then your decision to purchase replacement property for $300,000 (and cashing out for $700,000) will cause you to incur $700,000 of taxable income.

MISCONCEPTION 2: Replacing the original property with another property for the amount of the profit.
If you sold your property for $1 million and it originally cost you $800,000, then your decision to purchase replacement property for $200,000 (and cashing out for $800,000) will cause you to incur $200,000 of taxable income.

The IRS form 8824 (“Like-Kind Exchanges”) and instructions spell it all out.  Whatever cash you collect from selling your property is taxable up to the level of profit.  For certainty regarding the rules, talk to your CPA who can help you to understand the tax, cash flow and future income implications of purchasing replacement property.

For more information about replacement properties and 1031 exchanges, contact Peter Metz, CPA, Tax Principal of Grassi & Co. at pmetz@grassicpas.com.