Understanding 1031 Exchange Rules for Real Estate Investors Understanding 1031 Exchange Rules for Real Estate Investors
If you're a savvy real estate investor looking to take advantage of the benefits of a 1031 Exchange to defer paying capital gains tax on a transaction it can be overwhelming to grasp the rules and regulations of how Section 1031 of the U.S. Tax Code works. Don't get discouraged by the complexities of the process!
Quick Links
- What Is Section 1031?
- What is a 1031 Exchange?
- What is the Difference Between a Traditional Property Sale and 1031 Exchange?
- What Can Be Purchased as a Replacement Property in a 1031 Exchange?
- How Long Must a Property Be Owned to Qualify for a 1031 Exchange?
- Who Can Complete a 1031 Exchange?
- Does All of the Money in a 1031 Exchange Have to be Used?
- How Long Does It Take to Complete a 1031 Exchange?
- How Do I Identify and Acquire the Replacement Property?
- How Do I Get Started With a 1031 Exchange?
Whether you're looking to determine what property qualifies for a 1031 Exchange, how long a property has to be owned to qualify, or how long the whole process takes, we've answered some of the most commonly asked questions real estate investors need answered on how a 1031 Exchange works and all the 1031 rules you need to know the exchange process!
What Is Section 1031?
Before we get into everything you need to know about 1031 Exchanges let's talk about the law that makes these transactions possible. Internal Revenue Code Section 1031 grants investors the opportunity to defer capital gains taxes on the sale of real estate held for productive use in a trade business or for investment purposes by exchanging into like-kind replacement property(ies). IRC Section 1031 only applies to properties held for investment purposes and does not apply to primary or second homes.
What is a 1031 Exchange?
A 1031 exchange allows real estate investors to defer capital gains taxes on the sale of investment property, providing a path to potential wealth building. For full tax deferral, the exchanger must reinvest the net equity from the sale of their relinquished property and acquire a property with the same or greater debt.
What is the Difference Between a Traditional Property Sale and 1031 Exchange?
When a traditional sale occurs, the investor sells real estate and receives cash, thereby triggering a taxable event. During a 1031 Exchange transaction, an investor sells investment property and acquires more investment property (does not touch the cash). The sale proceeds are assigned to be held by a Qualified Intermediary at the close of the relinquished property.
What Can Be Purchased as a Replacement Property in a 1031 Exchange?
What are the characteristics a replacement property must meet in a 1031 Exchange? Generally, a seller can exchange property for another property when investing in real estate. How similar does the property you're selling and the property you're buying have to be? The property obtained through a 1031 Exchange has to be “like-kind” to the property sold. Whereas all “real property” may qualify, the term like-kind refers to how the real estate asset must be used or held for investment purposes. For example, commercial real estate can be exchanged for a single-family vacation rental property.
Property that does not qualify includes but is not limited to a primary residence, a second home, flip properties, or a property held in inventory for sale. When considering a 1031 exchange, it's important to note that recent changes to tax law disallow personal property (artwork, boats, etc.) as valid property in a 1031 Exchange at the federal level.
How Long Must a Property Be Owned to Qualify for a 1031 Exchange?
Section 1031 of the tax code does not clearly define a minimum amount of time for which taxpayers must hold the property. However, when the IRS examines exchange transactions, the taxpayer must be able to prove the property they're relinquishing was held for sale and that was their intent. Further, the IRS has indicated that two years of ownership is generally considered to be sufficient evidence of that intent.
Who Can Complete a 1031 Exchange?
The great thing is that a 1031 Exchange can help almost anyone looking to sell an investment property -- with a few caveats of course. The taxpayer of the property being sold must be the same taxpayer purchasing the new property. If Partnership ABC sells their property, Partnership ABC must complete the like-kind exchange. If a single person or individual entity sells a property, they must also buy the new property that completes the exchange. Section 1031 tax-deferred exchanges can accommodate Trusts, LLCs, and Corporations as well.
Does All of the Money in a 1031 Exchange Have to be Used?
So does the purchase of your new investment property have to be paid with exchange funds? For complete tax deferral, the taxpayer must reinvest all the net equity received from the sale of the old property and acquire a property with equal or greater debt than what encumbered the sold property. An exchange may still be valid if there is a shortfall of reinvestment, however, the transaction will likely result in some form of tax liability.
How Long Does It Take to Complete a 1031 Exchange?
The clock starts ticking on the day that the sale of the relinquished property closes. The taxpayer/exchanger has 45 days from the date of closing the relinquished property to identify (ID) replacement property, plus an additional 135 days to close on one or all the properties identified, totaling an entire exchange period of 180 calendar days. However, if your tax filing deadline for the year in which you sell the property occurs before this 180-day deadline, your actual time period may be shorter. Please consult with your tax advisor to discuss potential options available to you.
The identification must unambiguously describe the property (with an address or legal description) and must be made in writing, signed by the taxpayer, and sent before midnight of the 45th day. Replacement property that is acquired (i.e., closes) within the 45-day period is considered the purest form of identification and does not require an ID. There are specific rules and procedures when a 1031 Exchange spans two calendar years. Leader1031’s identification form is incorporated into our Exchange Agreement.
How Do I Identify and Acquire the Replacement Property?
You may be wondering whether you need to identify a replacement property before selling your current property. In a 1031 Exchange to avoid capital gains tax, identification must unambiguously describe the property (with an address or legal description), be made in writing, signed by the taxpayer, and sent within 45 days after the relinquished property is sold.
Generally, there are three identification rules that a 1031 Exchange must follow:
- Three-Property Rule: The investor may identify up to three properties regardless of value; or
- 200% Rule: They may identify any number of properties so long as the total fair market value of all the identified properties does not exceed 200% of the value of the sold property. NOTE: Exceeding 200% of the value will cause a third rule to apply (the “95% Rule”);
- 95% Rule: If the investor identifies more than three properties, and the combined value of all identified properties exceeds 200% of the value of the relinquished property, the taxpayer must acquire at least 95% of all identified properties, or the entire exchange will fail.
How Do I Get Started With a 1031 Exchange?
A good starting point for moving forward with a 1031 Exchange is to identify a team of trusted professionals including a tax advisor, realtor, and most importantly Qualified Intermediary (“QI”). When selecting a QI it is critical to verify the security of your funds during a 1031 exchange, and the knowledge base, and professionalism of your QI who will be interacting with your realtor, tax advisor, escrow, and replacement property representatives. As soon as your relinquished property has gone into contract, you can set up a 1031 Exchange account with Leader1031. This 1031 Exchange account and property legal documentation provided by your QI must be in place prior to the close of your relinquished property sale.
Leader1031 is ready to help ensure your transactions are in full compliance with IRS Code Section 1031 and related Treasury regulations. Contact Leader1031 today by email at 1031Exchange@LeaderBank.com or click below to learn more.
The content of this publication is provided as general information only and should not be taken as legal, investment or other professional advice. This content of this publication shall not be construed as a recommendation to participate in any particular trading, financial or investment strategy, and neither Leader Bank, NA nor Leader1031.com, LLC can provide legal or tax advice concerning the specific tax consequences of a given transaction. Any action that you take as a result of information or opinions provided in this publication is ultimately your responsibility. Consult your attorney, accountant, or tax professional before making any investment or financial decisions.
To ensure compliance with requirements under Treasury Department Circular 230, we inform you that the contents of this publication are not intended or written to be used, and may not be used, for the purpose of (i) avoiding U.S. federal tax penalties or (ii) promoting, marketing, or recommending to another party any matter addressed herein. Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser.
