Due to their wonderful tax benefits, every real estate investor should be educated on 1031 exchanges. With a 1031 exchange, you legally avoid paying capital gains tax when you sell a property you no longer wish to own and buy the next within a certain timeframe. Learn the rules of this investment strategy so you can reap the benefits.
There are four rules that must be followed in completing a fully tax deferred 1031 exchange.
1031 Exchange Rule 1: Exchange “Like for Like”
This rule is critical. If you botch this up, then you will pay the full tax as if it’s a SALE. The “like for like” rules means that you may exchange “qualified real property” for other “qualified real property.” It’s important to note that as of 2018, you can no longer have a tax deferred exchange of personal property for personal property.
The property that you sell must be classed as real property and must qualify for a 1031 and the property that you acquire must also be real property and must qualify for a 1031 exchange. If either do not qualify, then your exchange will be taxed as a SALE.
Here is how properties are “classed’ for tax purposes: by the intent of ownership at time of initial acquisition and by demonstrated subsequent use. Let’s look a little deeper:
- Qualified for a 1031: The following “intents of ownership” do qualify if owned for:
- investment purposes (for long-term value growth)
- a productive asset in your trade or business (you operate your business on that property); OR
- a generation of long-term rental income (you rent it out for others to use—a rental property).
- Not Qualified for a 1031: Property acquired to be renovated and resold in a quick resale (fixer-flipper properties, subdivision parcels, etc.) is not qualified. Both classify the owner as a “dealer” and dealers are not allowed 1031 tax treatment. Also, use of the property as your personal residence is not a disqualified asset in a 1031 exchange. However, there are other very important tax benefits applying to the sale of your home.
1031 Exchange Rule 2: You Must Exchange “Even or Up” in Both Value and Equity
To qualify for a fully tax deferred exchange, you must:
- Acquire property of equal of greater net value; and,
- invest all the net equity (net sale proceeds) held in the exchange impound account.
This means if you purchase a replacement property for the same net sale price as your relinquished property and use all the money in the impound account, then you would need to get a new loan as was on your relinquished property. Here are some options:
- Opportunity – Add Cash: Add other cash at closing to increase your purchasing capacity or to reduce the amount of loan needed to purchase your replacement property.
- Opportunity – Receive Some Cash: If you would like to receive some cash from your sale, then exchange the rest into a lower priced property, pocket the cash, and pay tax on the cash received at closing. The cash is classed as “taxable boot.” The rest of the gain could be deferred into the replacement property. This is an example of a partially tax deferred exchange.
My professional counsel is that you deal with a broker who is very familiar with 1031 exchanges and all the transaction options available to you. It is a great wealth adjustment and estate planning tool.
1031 Exchange Rule 3: Perform within Specified Time Frame
Once you close the sale of your relinquished property, there are two rigid performance periods required of a 1031 exchange:
- 45-Day Identification Period. You have 45 days to identify a restricted amount of replacement property that you are willing to accept. All must be within the United States or its possessions. There are three options here:
- Option One—Three Property Rule: Identify no more than three properties, but those properties may be of any value; or
- Option Two—200 Percent Rule: Identify as many properties as you would like, but their combined purchase prices cannot exceed twice the sale price of the relinquished property. Be careful here. Do not exceed the value limit or you will pay all the tax as if a SALE.
- Option Three—The Safety Net Rule: Identify any number of properties with no restriction on total value, but you must purchase at least 95 percent of all identified. This is a fairly dangerous option to use. But, it is a potential safety net if you botched options one and two.
Frequently Asked Question: What if you don’t properly identify any property in the 45-day ID period?
The answer is you will pay the full tax as if a sale. Once past that 45-day period, you can’t add to or substitute properties on that ID list.
If you only do exactly what the Internal Revenue Code requires and simply identify the properties, you will have a problem. If you do not (1) get any of the identified properties under contract, (2) do not perform the necessary due diligence inspections of those properties to make sure they met your standards, and (3) did not arrange for the necessary financing during the 45-day ID period, then you will have an issue. If all of your identified properties are purchased by other folks, or the owner decides later not to sell or dies in the process of your exchange, then even though these scenarios are not your fault, you will have to get out the checkbook and pay the tax on your relinquished property sale. Restated: Don’t do the minimum required by law.
- 180 Day Exchange Period: Clarification: of the 180 days allowed to complete the 1031, the first 45-day deadline is for identifying acceptable replacement properties; and, the remaining 135 days are for closing and completing the 1031. Look at it as 45 days and 135 days. Each is important in the process of the exchange.My professional observation is that you should try very hard to close the 1031 during the 45-day identification period. If a serious glitch occurs in attempting to close in the 45-day ID period, then there is still time to substitute for other acceptable replacement properties. Once past the 45-day period, that option no longer exists.
Frequently Asked Question: What if you can’t close the acquisition of the replacement property within the remaining 135-day period?
You will pay the full tax as if a SALE—even if the failure was clearly not your fault. This is why it’s wise to do everything that you can to close in the 45-day ID period. This may require the use of experienced exchange brokerage counsel and expertise, but it is worth it in the tax deferral process.
1031 Exchange Rule 4: Use a Qualified Exchange Facilitator to Complete the Exchange
It is still possible to complete a “simultaneously closing” tax deferred exchange, but very difficult to do properly. My professional recommendation is that you use a qualified exchange facilitator even if you’re doing a simultaneous closing exchange. They don’t cost very much compared to the expense of a screwed-up exchange and the requirement for full payment of the tax bill of a sale.
Every real estate investor should understand the 1031 exchange option. It’s a sound investment strategy with many benefits, but there are rules to follow. If you need help, contact me at 541-485-8100.