Build wealth and cash flow through experienced 1031 Exchange strategies. When you sell your interest in investment property, you may incur federal capital gains taxes and state taxes as well. Your attorney, tax advisor, or real estate professional may suggest a tax-deferred exchange under Section 1031 of the Internal Revenue Code. A tax-deferred exchange allows you to dispose of investment properties and acquire “like-kind” properties while deferring federal capital gains taxes and depreciation recapture. Most states with a capital gain tax offer a similar tax advantage, too. Bottom line: a tax-deferred exchange allows you to reinvest sales proceeds that would otherwise be paid to the government in the form of taxes.

Exchange Rules

Rule 1: Same Taxpayer
  • 1031 Exchange Rules: The tax return and name appearing on the title of the property that sells must be the tax return and titleholder that buys.
  • Exceptions exist for disregarded entities such as revocable trusts and single member LLC’s.
Rule 2: Property Identification
  • 1031 Exchange Rules: Post closing of the first property, the Exchangor has 45 calendar days to identify to either the accommodator or the closing entity the addresses of the potential replacement properties. regardless of value.
  • Three property rule – can identify any three properties
  • Two hundred percent rule – can identify four or more properties as long as the value does not exceed 200 percent percent of the property sold.
  • 95-percent exception rule – if the value exceeds 200 percent, then 95 percent of what is identified must be purchased.
Rule 3: Replacement
  • 1031 Exchange Rules: Within 180 calendar days following the closing of the first property or extension of the Exchangor’s tax return, the property must be purchased.
Rule 4: Trading Up
  • 1031 Exchange Rules: The net market value and equity of the property sold must be equal to or greater in the replacement property to defer 100 percent of the realized gain. Otherwise, the Exchangor needs to realize gain on the difference. Debt and equity in the replacement property must be equal to or greater than the debt and equity in the relinquished property. Additional equity in the replacement property offsets debt. Additional debt does not offset equity.
Rule 5: Hold Time
  • 1031 Exchange Rules: Though there is no hold time in the 1031 code, the Internal Revenue Service looks to determine whether the property was acquired immediately before the exchange. Was it purchased to fix and flip or held for productive use or investment?

Disclaimer: not fully inclusive – SEEK PROFESSIONAL LEGAL ADVICE

Deferred Exchange Requirements

The IRS Regulations to Section 1031 (adopted in 1991) specify the requirements necessary to accomplish a deferred like-kind exchange of real estate:

  1. Must designate a Qualified Intermediary (“QI”). Not necessary if the exchange is a simultaneous exchange of real estate.
  2. Written agreement must be entered into between the taxpayer and QI (Exchange Agreement).
  3. There can be no actual or constructive receipt of sale proceeds. The taxpayer cannot have a right to receive, pledge, borrow, or obtain the benefits of the exchange proceeds, except in very limited situations.
  4. Must be an exchange and transfer of qualified real property “held for productive use in a trade or business or for investment.”
  5. Fair market value (not equity) of qualified Replacement Property must equal or exceed the fair market value (not equity) of the Relinquished Property in order to avoid boot and recognition of gain.
  6. Written assignment of real estate contracts to QI.
  7. Written notice of real estate contract assignments.
  8. 45 days to identify, in writing, a limited number (or amount) of Replacement Property (identification period).
  9. 180 days to acquire the Replacement Property (or the date that the taxpayer’s income tax return is due, including extensions, whichever is earlier) (the”exchange period”). This later rule most often affects end-of-year exchanges, i.e., when the closing occurs between October 18 and December 31, because there are less than 180 days before April 15, the filing deadline for most taxpayers (some taxpayers may have an earlier filing deadline). The tax filing deadline (and replacement period) can be extended to achieve the maximum 180 days, but the taxpayer must file for an extension. May also be extended by declaration of a Presidential disaster (e.g., Greensburg, Kansas tornado, hurricane Katrina, etc.).
  10. Time-lines to identify and acquire the Replacement Property run concurrently, not aconsecutively. Clock begins to run when Relinquished Property is transferred.
  11. The Closing Statement should identify (i.e., name) QI as a principal to the transaction (e.g., “Seller: Exchange Corporation as Qualified Intermediary on behalf of Mr. and Mrs. Taxpayer”).

Mechanics of a Deferred Exchange

Step 1. The Taxpayer enters into a real estate sales contract for the sale of the relinquished property.

Step 2. The Taxpayer enters into an Exchange Agreement with the Qualified Intermediary.

Step 3. The Taxpayer assigns the real estate sales contract for the relinquished property to the Qualified Intermediary.

Step 4. The net sale proceeds from the closing on the sale of the relinquished property are paid to the Qualified Intermediary at closing to be deposited and/or invested in a short-term account on behalf of the Taxpayer.

Step 5. The Taxpayer conveys title directly to the buyer of the relinquished property.

Step 6. The Taxpayer identifies the replacement property within 45 days from the transfer date of the relinquished property and notifies the Qualified Itermediary.

Step 7. The Taxpayer enters into a real estate purchase contract with the seller of the replacement property to acquire the replacement property.

Step 8. The Taxpayer assigns the real estate purchase contract for the replacement property to the Qualified Intermediary.

Step 9. The closing on the purchase of the replacement property must occur by the earlier of (i) 180 days following the transfer date of the relinquished property, or (ii) the due date of the Taxpayer’s tax return for the year in which the transfer of the relinquished property occurred.

Step 10. The seller of the replacement property conveys the title directly to the Taxpayer.

Step 11. The Qualified Intermediary transfers the proceeds of the relinquished property to the seller of the replacement property, and any remaining proceeds are transferred to the Taxpayer as realized gain.