IRC Section 1031allows real estate investors to relinquish or sell one property and replace it with another like-kind property and defer payment of capital gains tax that would normally be due… We understand that the timelines and regulations of these transactions can be stressful, however our team is here to work tirelessly to meet your deadlines and ensure a smooth closing within your window of opportunity.
Basic rules of a traditional tax-deferred exchange are:
- Relinquished and replacement property must be like-kind
- Real estate must be used for business or investment purposes
- Replacement property must be the same or greater value than the property relinquished
- Boot – either in cash or a cash-like benefit – can not be received by the investor
- Name on the title on the replacement property must be the same as on the relinquished property
- Replacement property must be identified within 45 days of the closing of the sale of the relinquished property
- Replacement property must be purchased within 180 days of the closing of the sale of the relinquished property
While a 1031 exchange sounds simple enough, performing one can be tricky. A classical 1031 exchange involves a property swap between two individuals. However, this is rare, considering that finding someone with the type of property you want who is willing to exchange for your property is not always easy, quick or feasible.
Unless they are lucky, most property investors wanting to perform a 1031 exchange must do what is called a delayed exchange. You may also hear this type of exchange referred to as a three-party or Starker exchange, named after the legal case that established the procedure. This type of exchange works using thefollowing steps and rules:
1. Involve a Qualified Intermediary
Once you have decided to initiate a delayed 1031 exchange, begin by retaining a qualified intermediary. The qualified intermediary is a person or company with no stakes in the exchange that manages the funds involved. The intermediary holds on to the proceeds from the sale of your property, then transfers the funds to the seller of the replacement property or properties.
The reason for this third party is to allow for delayed exchanges and ensure the funds from the sale are held in a way that enables them to remain non taxable until the time limit for the 1031 exchange passes.
2. Identify a Property
The seller has an identification window of 45 calendar days to identify a property to complete the exchange. Once this window closes, the 1031 exchange is considered failed and funds from the property sale are considered taxable. Due to this slim window, investment property owners are strongly encouraged to research and coordinate an exchange before selling their property and initiating the 45-day countdown. Fortunately, investors have multiple identification strategies available, which are summarized in three rules:
Three Property Rule: Also known as the Three Property Identification Rule, the Three Property Rule allows investors to identify a maximum of three potential like-kind replacement properties regardless of their fair market value. After identification, the investor could then acquire one or more of the three identified like-kind replacement properties as part of the 1031 exchange. This method is the most popular 1031 exchange strategy for investors, as it allows them to have backups if the purchase of their preferred property falls through.
200% Rule: The 200% of Fair Market Value Identification Rule states investors can identify an unlimited number of like-kind replacement properties, provided the total value of all properties at the end of the period doesn’t exceed 200% of the relinquished property’s total net sales value. If an investor wants to perform a 1031 exchange on a property with a sales value of $1 million, they can identify as many replacement properties as desired as long as those properties’ total value doesn’t exceed $2 million. This strategy is often preferred by investors looking to acquire over three investment properties or seeking extra backup properties if a sale falls through.
95% Exception: The 95% Identification Exception states investors can identify an unlimited number of potential replacement properties with an unlimited fair market value, provided the investor acquires and closes on 95% of the identified market value. This technique is most often used by investors who exceed the 200% rule at the close of the identification period. Using this exception may be an intentional choice if the investor seeks to purchase multiple properties. It may also happen inadvertently from sudden property value increases. Either way, this gets around the 200% rule while still meeting 1031 exchange requirements.
It’s important to note that if the investor fails to identify properties or identifies more properties than allowed by the Three Property Rule or the 200% Rule and cannot apply the 95% Exception, then the 1031 exchange is considered failed.
3. Purchase a Replacement Property
Once the replacement properties are identified, the seller has a purchase window of up to 180 calendar days from the date of their property sale to complete the exchange. This means they have to purchase a replacement property or properties and have the qualified intermediary transfer the funds by the 180-day mark.
This window may be shorter if the due date of the income tax return for the tax year in which the previous property was sold falls within the 180-day window. In which case, the sale is due by the tax return date. If the deadline passes before the sale is complete, the 1031 exchange is considered failed and the funds from the property sale are taxable.