Concise Overview of 1031 Exchanges
You should always consult with your legal, tax and financial advisors to determine which tax deferral or tax exclusion strategy is the most suitable for your specific circumstances. This article has been written as a concise overview of 1031 Exchanges. It is only a brief summary to assist you in understanding the very basic 1031 Exchange rules and requirements. You can read an Introduction to Section 1031 Tax Deferred Exchanges for a more complete and in depth explanation of 1031 Exchanges. Let's start by answering the question 'what is a 1031 Exchange'.
What Is A 1031 Tax Deferred Exchange?
The 1031 Exchange allows you to sell one or more appreciated assets (generally rental or investment real estate, but could be non-real-estate) and defer the payment of your capital gain taxes by acquiring one or more replacement properties. 1031 Tax Deferred Exchanges allow you to keep 100% of your money (equity) working for you instead of paying (losing) about one-third (1/3) of your funds (equity) to taxes.
There are, of course, very specific requirements that you must follow so that your sale transaction will qualify for 1031 Tax Deferred Exchange treatment under Section 1031 of the Internal Revenue Code (tax code).
1031 Tax Deferred Exchange Requirement
The sale and the purchase transactions must be structured properly in order to qualify for tax-deferred treatment under a 1031 Exchange. The Qualified Intermediary, often referred to as the 1031 Exchange Accommodator or the 1031 Exchange Facilitator, will complete the necessary legal documents to ensure that you are in compliance will all laws, regulations and rulings.
It is critical that the Qualified Intermediary be assigned into the Purchase and Sale Agreement or Contract and the Escrow Instructions, if any, prior to the close of your sale and purchase transactions. Your transaction will not qualify for 1031 Exchange treatment if either transaction closes without your Qualified Intermediary being formally assigned into both transactions.
Reinvesting or Replacing Your Investment Values
You must acquire one or more replacement properties that are equal to or greater in net purchase value than the net sales value of the relinquished property you sold. You must reinvest all of your net cash proceeds from the sale of the relinquished property. And, you must replace the debt that was paid off on the sale of the relinquished property with an equal amount of debt on the like-kind replacement property.
You can always add more cash into your purchase of your like-kind replacement properties, but you can not pull any cash out of the sale of your relinquished property without incurring depreciation recapture and/or capital gain income tax liabilities.
Qualified Use Requirement
Your relinquished properties and your like-kind replacement properties must have been held as rental or investment properties or used in your trade or business. The critical issue is that you must have the intent to hold the properties for investment purposes and not have held them for sale (i.e. inventory in your real estate business such as a flipper, rehabber, developer or builder).
Like Kind Property Requirement
There is a lot of misinformation regarding what constitutes like-kind replacement property. It is not true that if you sell a condo you must acquire a condo, etc. As long as your relinquished and replacement properties meet the qualified use requirement discussed above any kind of real estate held for investment is like kind to any other kind of real estate that is also held for investment.
You can exchange out of or into any of the following asset types: single family, multi-family, commercial office, retail shopping, industrial, vacant land, oil and gas interests, mineral rights, riparian water rights, and tenant-in-common investments.
Multiple Assets and Fractional Interests
The 1031 Exchange allows you to easily reposition, diversify or consolidate your investment real estate portfolios. You can sell one relinquished property and diversify your portfolio by acquiring multiple like-kind replacement properties, or you can sell multiple relinquished properties and consolidate your portfolio by acquiring fewer but larger like-kind replacement properties. You can also sell or purchase fractional (partial) interests in property.
1031 Exchange Structures
The most common 1031 Exchange structure is a Forward, or Delayed, 1031 Exchange where you sell your relinquished property first and then acquire your like-kind replacement properties within the prescribed 1031 Exchange deadlines. A Reverse 1031 Exchange allows you to acquire your like-kind replacement property first and then subsequently dispose of your relinquished property within the prescribed 1031 Exchange deadlines. An Improvement (Build-To-Suit 1031 Exchange or Construction 1031 Exchange) 1031 Exchange allows you to use your 1031 Exchange funds to acquire like-kind replacement property and to use your excess 1031 Exchange funds to construct or improve the like-kind replacement property acquired.
1031 Exchange Deadlines
There are very specific and mandatory 1031 Exchange deadlines that must be followed in a forward 1031 Exchange. You have 45 calendar days from the close of the relinquished property transaction to identify potential like-kind replacement properties being considered for purchase and an additional 135 calendar days — for a total of 180 calendar days — to complete the 1031 Exchange by acquiring some or all of the identified like-kind replacement properties.
1031 Exchange Identification Requirements
You must identify your potential like-kind replacement properties to your Qualified Intermediary within the 1031 Exchange time limits discussed above. The identification must comply with one (1) of the like-kind replacement property identification rules outlined below:
Three (3) Property Identification Rule
The three (3) property identification rule is the most common rule and is used in most 1031 Exchange transactions. This rule allows you to identify up to but not more than three (3) potential like-kind replacement properties. It is highly advisable that you identify three (3) properties even if your intent is to only acquire one. If you are looking to diversify your investment real estate portfolio and needs to identify more than three potential like-kind replacement properties one of the following two rules should be considered.
200% of Fair Market Value Identification Rule
The 200% of fair market value rule allows you to identify more than three (3) potential like-kind replacement properties as long as the total fair market value of all the potential like-kind replacement properties identified does not exceed 200% of the sales price of the relinquished property(ies).
95% Exception to Identification Rules
The 95% exception to the identification rules allows you to identify as many like-kind replacement properties as you wish provided you actually acquire and close on 95% of the fair market value actually identified.