When it comes to real estate investing, the 1031 exchange is a powerful tax-deferment strategy used by investors. It allows an investor to defer paying capital gains taxes on an investment property when it is sold – as long another “like-kind property” is purchased with the profit gained by the sale of the first property. Essentially you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain, allowing your investment to grow tax deferred.
If you’re considering a 1031 exchange, here are 6 rules to start you on your way.
1. The Property Must Be Like-Kind
In a 1031 exchange, the investor must acquire a “like-kind” property and it must be for investment or business purposes.
There is a common misconception that about what this means. Just because you sell a condo, does not mean you need to acquire another condo. You could buy another asset type such as a single family or multi-family home, a commercial office or retail space – as long as both properties meet the IRS qualified use requirement. Most real estate will be like-kind to other real estate.
A couple things to keep in mind about the properties:
- You cannot use a primary residence in a 1031 exchange.
- The properties to exchange cannot be outside of the U.S.
- While you can never purchase the replacement or new property from a related party, you can sell a property to a related party – although this requires a 2 year holding period.
2. 45-Day Property Identification Period
There are a couple of strict timelines you must follow when completing a 1031 exchange. With the first, beginning the day after you sell (or relinquish) your property, you will have 45 calendar days to identify property(s) of equal or greater value. The property you purchase must be one (or more) of the properties you identified in the 45-day period. A new property cannot be added after this time frame.
Property identification is also subject to the following rules:
- Three Property Rule: You can identify up to three new properties without regard to cost.
- 200% Rule: You can identify more than three properties as long as the value does not exceed 200% of the property sold.
- 95% Exception Rule: If the value of these properties exceeds 200%, then 95% of what is identified must be purchased.
3. 180-Day Purchase Period
The second timeline also begins when you relinquish your property and it runs concurrently to the 45 days. Section 1031 requires that the purchase and closing of one or more of the new properties occur by the 180th day of the closing of the old property. No extensions are given, so you must close by the 180th.
4. A Qualified Intermediary Is Required
According to the IRS safe harbor provisions, you must execute a written agreement with a Qualified Intermediary (QI) to execute a 1031. This independent 3rd party cannot be a relative or your attorney, agent, broker, CPA, etc.
To successfully complete a 1031 exchange (and preserve the tax benefits), the seller(s) cannot touch the money in between relinquishing the old property and purchasing the new one. The QI acquires your property, sells it on your behalf, buys the new replacement property and then transfers the deed of trust to you. It is their responsibility to prepare the necessary exchange documentation, hold and protect the exchange proceeds and ensure the transaction is completed within IRS guidelines.
5. The Taxpayer Must Be The Same On Both Titles
A 1031 exchange requires that the taxpayers name appearing on the old property be the same as taxpayer(s) listed on the new one. For example, if a corporation is on the title to the original property, then that same corporation must be listed on title to the new property.
6. An Equal Or Greater Amount
To defer 100% of the capital gains taxes on the sale of the old property, the new property must be of equal or greater value. All the net proceeds from the relinquished property must be reinvested AND the debt that was paid off must be replaced with an equal or greater debt.
If you choose not to use all the sale proceeds, or you decrease your liability (which is treated as income) you’ll have to pay the applicable capital gains taxes on the difference. This is referred to as “boot.”
1031 Exchange Risks
As with any type of investment, there are risks associated with a 1031 exchange. Understanding these basic rules is just the beginning. A 1031 exchange is incredibly complicated, even for experienced investors. A small mistake can jeopardize the deferment of your capital gains taxes, which is why most investors seek professional help to develop a strategy and get the deal done right.
Disclaimers: 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 an overview of 1031 Exchanges. It is only a brief summary to assist you in understanding the very basic 1031 Exchange rules and requirements.
Citywide Home Loans does not provide Qualified Intermediary services, tax services or any other service apart from lending.