Many investors who are planning to save taxes via a 1031 Exchange fail to fully follow IRS guidelines and end up with tax liabilities that could be avoided. Let’s review the basic 1031 Exchange rules to understand the steps that must be taken to complete a 100% tax free investment.
- The same tax payer entity who sells the property must be the same entity who buys the replacement property. For example, if you sell property owned as an individual or an LLC or a trust, you must purchase your replacement property in the same entity as what appeared on your prior tax return. An exception is that if a property is owned in a pass-through entity such as a single person LLC, the replacement property may be owned in the name of the individual.
- Replacement property must be “like-kind.”“Like-kind” means that both the relinquished and replacement properties must be “properties for business use (not personal property) which have the same nature or character, even if they differ in grade or quality.” For real estate, the IRS permits a broad definition of “like-kind” and you can sell one asset class e.g., land, retail, apartments, etc. and reinvest into another real estate asset class. You are not permitted to sell and exchange business use equipment e.g., farming equipment, machinery, etc. into real estate (or vice versa).
- Carefully follow one of the permitted property identification rules.
- Three property rule –identify up to three properties regardless of value (this is the most common rule)
- 200% rule –identify four or more properties having a total value that does not exceed 200% of the property sold (this rule is often used when purchasing a portfolio of properties)
- 95% rule – identify any number properties exceeding 200% of the value of the property sold and purchase 95% of what was identified (this rule is difficult to execute and rarely used)
- Do not go beyond allowed timeframes to complete the identification of your replacement properties.As a seller, you are allowed up to 45 days (including non-business days) after the close of your sale (i.e., close of escrow date) to complete the identification of your replacement properties. You then have up to 180 days from the close of your sale to acquire the properties that you have identified. These rules are rigorously enforced and failure to precisely follow them can lead to severe penalties. TIP: If you need more time to find suitable replacement properties, start your search before you close your sale.
- Observe “equal to or greater.”The net market value and equity of the property sold must be exactly equal to or greater in the replacement property to defer 100% of the tax. Any leftover proceeds whether equity or debt (called “boot”) will be subject to potential taxes. Keep in mind that both debt and equity in the replacement property must be equal to or greater than the debt and equity in the relinquished property. While you are permitted to offset debt by investing additional cash, you must reinvest 100% of the equity in the sold property and cannot offset any portion of that equity with additional debt. In other words, additional cash can offset debt, but additional debt does not offset equity. As an example, if you are selling a $1,000,000 property with a $750,000 loan, they would have to buy $1,000,000 or more of replacement property with at least $250,000 or greater equity.
- Fundscannot be held by a related party. When your sale is closed, all funds must be transferred to a non-related party who will hold your funds until reinvested in the replacement properties. This function is performed by a 1031 Exchange Accommodator or Qualified Intermediary who will earn a nominal fee for providing this service. Note that there are no specific requirements that must be met by a QI other than they cannot be a “related party” (see Section 267(b) or Section 707(b)(1) of the Internal Revenue Code). So be sure to fully check out the background of your selected QI before you sign their agreement and allow them to take control of your funds. There have been abuses by dishonest QIs that have resulted in investors losing money.
- Investment duration.While there is no specific hold time in the 1031 code, the IRS does consider the length of ownership in determining whether a full tax deferral will be allowed. The shorter the ownership period, the more substantial should be the facts supporting the intent to hold the property for a productive use versus a quick flip for profit. Furthermore, the IRS strictly limits personal use of business properties e.g., no more than 14 overnights per year for vacation properties.
Practically speaking, it can be a challenge to complete a 100% tax free exchange. However even a partial 1031 Exchange where most or even some of the proceeds can be shielded from tax liabilities can result in a more favorable outcome than not doing any 1031 Exchange.
Due to the complexity of the IRS guidelines, we strongly advise all investors who are considering a 1031 Exchange to seek the advice and guidance of experienced and reputable tax specialists.