The origin of 1031 Exchanges dates to 1921 and the related provisions which permit tax deferrals have been extensively used by many taxpayers to save taxes. While specific details have evolved over time, there are basic rules outlined below which apply to almost all 1031 Exchanges and 1031 Exchange Properties
Rule #1 – Both the property being sold and the property being acquired must be held for a period of an investment or used in a trade or business. The taxpayer’s primary residence will not qualify.
Rule #2 –The properties in an exchange must be “like-kind.” Fortunately, the IRS allows a very broad interpretation of what is permitted and any type of income producing real property can be exchanged including land to apartments, apartments to commercial, a single-family rental to a retail store, etc. Only real properties qualify and other forms of real estate ownership such as REITs, stocks, partnership interests, etc. do not qualify.
Rule #3 – Stated time limits must be strictly observed. From the day you close the sale of your income property, you have 45 days to identify the properties you might want to buy. The most common identification rule allows you to list up to three properties with no limitations. There are allowed options for identifying more than three properties if desired. You will then need to close the purchase of your replacement properties within 180 days of the date of the sale of your property (or 135 days after your 45 day identification period expires). Carefully note that days are measured as calendar days and include weekends and holidays. There is generally no exceptions and failure to follow these dates will result in a loss of all potential benefits.
Rule #4 – You are not allowed to take control or possession of any of the sales proceeds related to the exchange. Any funds that you receive will be subject to taxes and no longer eligible for a 1031 Exchange. The rules require that your sales proceeds be transferred to the account of an independent third party called a Qualified Intermediary or Accommodator who will complete the exchange on your behalf. Unfortunately, Qualified Intermediaries are not licensed or regulated and there have been past abuses when unsuspecting investors allowed their funds to be transferred to Qualified Intermediaries who misused and even lost funds. Fortunately, there any many reputable firms that provide Qualified Intermediary services and only those who have been properly qualified should be considered.
Rule #5 – The entity that holds the title to the sold property must be the same entity that purchases the replacement property. Any entity, such as individuals, corporations, trusts, partnerships, LLCs, etc. may do an exchange. For example, if Paul and Jan are married and hold joint title to an income property they are selling, both Paul and Jan must take title to the new replacement income property.
Rule #6 – To defer all of your capital gains tax, you must a) buy a property of equal or higher value than the one you sold b) you must reinvest all of the cash proceeds from the sale and, c) you must replace all of the debt on your sold property with either same or greater debt or invest added cash to offset the debt. As an example, if you sell a property worth $1 million that has $500,000 of equity and a $500,000 loan, you must replace the sold property with a property valued at $1 million or greater having at least $500,000 in equity from your sold property. You can add more cash at any time without negatively impacting the exchange.
These are the basic rules that apply to almost all 1031 Exchanges and 1031 Exchange Properties. However, the tax code governing the full range of 1031 Exchange options and complications that can exist runs to many hundreds of pages. All investors who wish to consider a 1031 Exchange are strongly advised to seek the advice of a qualified tax advisor before initiating the exchange process.
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