What is the 1031 Exchange Process and 1031 Exchange Rules? What is the 1031 Exchange Process and 1031 Exchange Rules?
A 1031 exchange is a tax code structure available to real estate investors to defer capital gains taxes by selling an investment property and purchasing like-kind replacement property. Through Section 1031 of the U.S. Tax Code, investors can complete 1031 exchanges to carve out a path to potential wealth building.
This process can be complex, which is why it is important to work with a supportive Qualified Intermediary. Leader1031, a leading national qualified intermediary assists in qualifying 1031 exchanges by offering expertise on the sale and purchase of investment properties. The advantages of using IRC Section 1031 as a wealth-building strategy come with precise timelines, rules, and regulations. Below, we'll dive into the details of the 1031 exchange process, how an exchange works, and the 1031 exchange timeline.
Key Takeaways:
- Taxpayers looking to use a 1031 exchange to defer capital gains tax have 45 days once they sell the property to identify a like-kind property (or properties) of equal or greater value.
- Following day 45, taxpayers have an additional 135 days (if needed) to close on any identified property (or properties).
- In total, investors must acquire the replacement property and complete a like-kind exchange within 180 days of closing on the relinquished property.
What is the 1031 Exchange Timeline?
Taxpayers looking to use a 1031 exchange to defer capital gains tax have 45 days once they sell the property to identify a like-kind property (or properties) of equal or greater value plus an additional 135 days (if needed) to close on any identified property (or properties). In total, investors must acquire the replacement property and complete a like-kind exchange within 180 days (45+135=180).
The 45-day identification period starts the day the relinquished property sale closes. The exchanger has up to midnight of the 45th calendar day to unambiguously describe, in writing to the Qualified Intermediary, the like-kind property or properties they intend to purchase. The taxpayer is not required to close on all properties identified and can revoke or revise their identification at any point prior to midnight on the 45th day.
If an exchanger revokes their identification and has zero like-kind properties identified, then the sale proceeds that the Qualified Intermediary is holding on behalf of the exchanger will be wired directly back to the taxpayer on day 46, triggering a failed exchange, taxable event, and resulting in the exchanger paying capital gains tax on the proceeds from the sale (as they would had they not entered an exchange).
1031 Exchange Rules: What are the 45-Day and 180-Day Deadlines?
Wait, so there are two different deadlines for different parts of the 1031 exchange process? If you're confused – don't worry, we're going to break down each of these deadlines so you know where you stand when you begin the search for potential replacement properties for your 1031 exchange.
The taxpayer must identify a new property or properties within 45 days from the date of closing on the relinquished property. Proper identification of a replacement property is a requirement for a valid exchange, and the investor can only acquire property which has been properly identified during the 45-day identification period. A like-kind property that is acquired (i.e. closes) with the 45-day period is considered properly identified. For property not acquired within the first 45 days, the identification must unambiguously describe the property (with an address or legal description), must be made in writing, signed by the taxpayer, and sent before midnight of the 45th day. If multiple relinquished properties are grouped together in one exchange, the 45-day period starts to run as of the closing of the first relinquished property.
Rules You Need to Know for a Section 1031 Like-Kind Exchange
Within the 45 day identification period, the taxpayer must use one of the following rules:
- Three-Property Identification Rule: The investor may identify up to three replacement properties regardless of their fair market value. This does not mean that the taxpayer must close on all three properties. It's simply an opportunity to purchase one or more of those three properties through the exchange.
- The 200% Rule: The investor 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 relinquished property. Note: exceeding 200% of the value causes the third rule to apply.
- 95% Rule: If more than three replacement properties are identified and the sum of all identified properties exceeds 200% of the value of the relinquished property, then the taxpayer must acquire at least 95% of the total fair market value of all identified properties, otherwise, the entire exchange will fail.
Each of the three rules outlined above applies to a range of different investors and are not one-size-fits all. It's important to work with a Qualified Intermediary to determine the best way to complete your specific exchange.
How Long Must a Replacement 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 investment property once an exchange is complete. However, when the IRS examines exchange transactions, it is often recommended that the taxpayer be able to provide evidence indicating the relinquished property was held for investment for a minimum of one year and one day.
How to Get Started With a 1031 Exchange
The first step investors should take when exploring the benefits of a 1031 exchange is to ensure they have surrounded themselves with the appropriate team of professionals to guide them through the process including a tax advisor, attorney, real estate agent, and Qualified Intermediary.
Finding the right Qualified Intermediary to work with is crucial to the 1031 exchange process because it helps verify the security of your funds and provides your entire team with knowledge and experience that they might not otherwise have.
Your qualified intermediary will interact with your realtor, tax advisor, escrow professional, attorney, and representatives for the property you are purchasing, so it's extremely important to make sure you choose a QI who can guide your team through the complexities of the process while meeting all of the important associated deadlines.
Leader Bank's 1031 exchange subsidiary, Leader1031*, serves as a qualified intermediary for real estate investors seeking to sell and purchase property using the tax-deferred advantages of a 1031 exchange. These services provide greater integration and efficiencies for our commercial real estate clients, and Leader1031 is committed to providing the highest quality of service.
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 certain 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. Contact Leader1031 today!.
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.
