What is a 1031 Exchange?
DEFINITION
Internal Revenue Code Section 1031 allows investors to defer the payment of capital gains taxes when selling an investment property and exchanging into another investment property.
Four Types of Exchanges
DELAYED EXCHANGE
This is the most common method of exchanging; the delayed exchange allows investors to sell a property and then acquire replacement property within 180 days.
SIMULTANEOUS EXCHANGE
This is the most common method of exchanging; the delayed exchange allows investors to sell a property and then acquire replacement property within 180 days.
REVERSE EXCHANGE
Allows investors to acquire the replacement property prior to selling. The reverse exchange can be more complicated however, as investors cannot own both the new replacement property and (soon to be) relinquished property at the same time.
CONSTRUCTION/ IMPROVEMENT EXCHANGE
The construction exchange allows investors to use exchange proceeds to build on land or improve existing property. The construction/improvement exchange is often used to acquire a 'fixer' and do improvements on the existing structure. Not all clients qualify for a construction exchange, so please schedule an appointment to to discuss the process.
THE EXCHANGE GUIDELINES
DISCLAIMER
Strict adherence to the legal requirement of Section 1031 of the Internal Revenue Code is required for a successful exchange. Investors should always be aware of the four basic requirements when entering into a delayed exchange and should seek the advice of a tax accountant or attorney to ensure proper adherence to the tax code.
1) PROPERTY QUALIFICATION
The Internal Revenue Code states that the properties involved in an exchange must be held for productive use in trade or business for investment and they must be "like-kind".
2) TIMELINE
The IRS provides a maximum of 180 days to complete an exchange. The timeline begins upon the close of escrow (COE) of the relinquished property. The new property (or properties) must be acquired on or before midnight of the 180th day. No exceptions! In addition, the IRS requires that all potential replacement properties be identified by midnight of the 45th day of the exchange.
3) IDENTIFICATION
Identification of all potential replacement properties is required on, or before, day 45 of the exchange. Identification must be in writing and the description of the properties must be unambiguous. The IRS provides two rules for identifying replacement property:
a) The 3 Property Rule - allows for identification of any three properties, for any price, anywhere in the United States
b) The 200% Rule - is an option for identifying more than three properties. With the 200% Rule, four or more properties can be identified. However, the combined value of all properties identified cannot exceed 200% of the property sold
4) TAX DEFERRAL
To defer 100% of the capital tax liability, two requirements must be met:
a) Reinvest all the Cash - All the ash that was generated from teh sale of the relinquished property must be reinvested into the new property or properties
b) Purchase Equal or Greater in Value - The new property, or properties, must be equal or greater in value to the property sold
Frequently Asked Questions [FAQ]
Q)
How long do I have to own a property before I can exchange it?
A)
Generally, the longer the better. Unfortunately, there is no safe holding period for property to automatically qualify for an exchange. Keep in mind, the property only needs to be "held for investment" for it to be eligible for an exchange. Time of ownership is only one factor the IRS looks at when determining if the property was "held for investment". Some tax advisors recommend a minimum holding period of one year.
Q)
Can I sell my duplex and purchase raw land?
A)
Certainly. Properties involved in an exchange need to be held for either productive use in trade or business or for investment. Holding land for future appreciation is considered held for investment. Do not get confused by the "like-kind" requirement. "Like-kind" can mean any real property used for business or investment purposes within the United States.
Q)
Can I buy my replacement property first?
A)
Yes. This requires a reverse exchange. A reverse exchange may be an option provided it is structured according to the safe harbor guidelines.
Q)
Can I move into a rental property that was originally purchased as a part of a 1031 Exchange?
A)
Yes. However, please keep in mind that the IRS will look at your "intent" in determining if your exchange is valid. If the IRS feels your original intent when the property was initially acquired was to use it as a primary residence, you may have your exchange disqualified. We recommend renting a property out at least for 2 years before using it for personal use.
Q)
Do I have to reinvest all of my cash (equity)?
A)
No, you do not. However, any cash (equity) that is not reinvested in real estate will be taxable; this is known as a cash boot. The general rule of thumb is, if you don't want to pay any taxes, is to reinvest all of your cash and purchase a property equal or greater in value.
Q)
How long do I have to complete my exchange?
A)
You have 180 days to complete the exchange. However, also keep in mind you will be require to identify your potential replacement properties on day 45 of your exchange. Your timeline starts when you close escrow on the property you're selling.
Q)
Have more questions?
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