1031 Exchange Info for Investors
Introduction to 1031 Exchanges
A 1031 exchange allows a taxpayer (Exchangor) to sell his or her existing property (relinquished property) and purchase more profitable and productive property (replacement property) while deferring Federal, and in most cases state, income taxes.
Full or Partial Tax Deferral
Exchangors must meet certain requirements in order to defer 100% of their Federal, and in most cases state, income taxes on the sale of investment property. Generally, for full tax deferral, the Exchangor must (1) acquire replacement property that is equal to or greater in value (based on net sales price, not equity) than the relinquished property; and, (2) must reinvest all of the net proceeds (net equity) from the sale of the relinquished property.
A 1031 exchange can also be used for a partial tax deferral when an Exchangor trades down in value or wishes to pull cash out. In this case, the amount that is not exchanged for qualified replacement property becomes boot and maybe taxable.
Exchange Structures
The most common 1031 exchange structure is a forward, or delayed, 1031 exchange. In this case, the Exchangor sells his or her relinquished property first, and then acquires his or her replacement property, either on the same day or at a later date. Closing both transactions on the same day is referred to as a simultaneous or concurrent 1031 exchange. Closing the sale transaction first and closing the purchase transaction later is referred to as a delayed 1031 exchange.
The opposite structure is referred to as a reverse 1031 exchange. This is when the Exchangor acquires the replacement property first and sells his or her relinquished property at a later date. Reverse 1031 exchange transactions are much more complex than forward 1031 exchanges.
The Qualified Intermediary
The Qualified Intermediary, often referred to as the Accommodator or Facilitator, is the central component in a 1031 exchange. The Qualified Intermediary will draft the legal documents necessary to structure and document the 1031 exchange transaction. The Qualified Intermediary will also be assigned into each “sale” and “purchase” transaction and will hold and safeguard the 1031 exchange funds during the 1031 exchange process.
Basic Rules and Requirements
Qualified Use Property:
The Exchangor must have held the relinquished property for rental, investment or use in his or her business. And, the Exchangor must have the INTENT to HOLD the replacement property for rental, investment or use in his or her business. Property not held for rental, investment or use in a trade or business is not considered to be qualified use of property and will not qualify for 1031 exchange treatment.
Like-Kind Property:
The relinquished and the replacement properties must be like-kind in order to qualify for 1031 exchange treatment. In regards to real estate, ANY type of real property is like-kind to ANY other type of real property, so long as the qualified use test referenced above has been met.
Taxpaying Entity (Exchangor):
The replacement property must be acquired by the same taxpaying entity that sold the relinquished property. However, there are some exceptions to this rule not discussed in this article. Exchangors should consult with an experienced Qualified Intermediary for further information.
Multiple Properties and Fractional Interests:
Exchangors can sell multiple properties and/or acquire multiple properties. For example, a house may be exchanged for two condominiums or vice versa. The relinquished and/or replacement property can also involve a fractional or partial interest in the property.
Exchange Requirement:
The Exchangor must ensure the transaction is structured as a tax-deferred, like-kind exchange and not a sale and subsequent purchase. Also, both the relinquished and replacement property transactions must be part of an integrated plan or transaction. An experienced Qualified Intermediary can assist you with this process.
Identification Requirements:
The identification process is the step where the Exchangor identifies his or her potential replacement properties that are being considered for acquisition. This is only an identification requirement and the properties do not need to be under contract or in escrow. However, they must be identified and specifically named to the Qualified Intermediary. To qualify for a 1031 exchange, this step requires the Exchangor to comply with one (not all) of the following three identification requirements:
1) The Three (3) Property Rule:
The three (3) property identification rule allows the Exchangor to identify up to, but not more than, three (3) potential replacement properties. With the three (3) property rule, there is no limitation on the market value of the identified potential replacement properties. There is only a limitation on the total number of potential replacement properties that the Exchangor may identify. Although he or she could do so, the Exchangor is certainly not required to acquire all of the properties identified. The three (3) property rule allows Exchangors the ability to identify more than one property so they have back-up properties identified in case their first choice cannot be acquired. This is the most common and the easiest of the identification rules to work with.
2) The 200% of Fair Market Value Rule:
Unlike the three (3) property rule, the 200% rule allows the Exchangor to identify more than three (3) potential replacement properties as long as the total fair market value of all the potential replacement properties identified does not exceed 200% of the sales price of the relinquished property(ies). There is no limitation on the total number of potential replacement properties identified with this rule, only a limitation on the total fair market value of the potential replacement properties identified by the Exchangor. For example, if the Exchangor sold relinquished property for $1,000,000 he or she would be able to identify as many potential replacement properties as he or she wanted, provided that the total fair market value of all of the identified potential replacement properties combined did not exceed $2,000,000.
3) The 95% Exception Rule:
In the event the Exchangor must identify replacement properties that exceed the three (3) property rule and the 200% of fair market value rule, the identification will still be considered valid for 1031 exchange treatment if the Exchangor acquires at least 95% of the property value identified.
Time Restrictions:
1031 exchanges are subject to very specific time restrictions or deadlines that cannot be extended, waived or altered for any reason.
45 Calendar Day Identification Period
In a forward/delayed 1031 exchange, the Exchangor has 45 calendar days from the close of his or her sale transaction (and the transfer of the title to his or her relinquished property) to identify potential replacement property(ies) to be acquired. The deadline is not extended if the deadline falls on a Saturday, Sunday or legal holiday.
The Exchangor can change his or her mind as often as he or she wishes within the 45 calendar days by revoking any prior identifications and submitting a new identification to the Qualified Intermediary. The identification can not be changed or altered after the 45 calendar day deadline has passed.
180 Calendar Day Exchange Period
In order to successfully complete the transaction as a 1031 exchange, the Exchangor must complete the acquisition of one or more of his or her identified replacement property(ies) no later than either (1) 180 calendar days from the close of his or her sale transaction, OR (2) by the due date, including extensions, of his or her Federal income tax return.
Actual or Constructive Receipt:
The Exchangor is not allowed to have any actual or constructive receipt of the exchange funds during the exchange period. The Exchangor is considered to have actual or constructive receipt of the 1031 exchange funds at the time he or she has actual possession of the funds or receives any economic benefit from the funds or assets. Actual or constructive receipt by the Exchangor of any portion of the 1031 exchange funds or assets during the exchange period will result in a taxable event and may result in the complete disallowance of his or her 1031 exchange transaction. In order to avoid this, a Qualified Intermediary must be assigned into the purchase and sale agreements (and escrow instructions if applicable) of the relinquished property and the replacement property before either transaction closes and the properties are transferred to the respective buyers. If either transaction should close before the Qualified Intermediary has been assigned into the transaction, the transaction will fail to qualify as a 1031 exchange.
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