1031 Exchange Rules: All you need to know
A 1031 Property Exchange is the best tax-free strategy to sell your real estate investment property and purchase another. A 1031 exchange presents a valuable opportunity to avoid paying taxes on the sale of your investment. With this huge incentive comes responsibility to adhere to the rules as per Section 1031 of the code of the Internal Revenue Service (IRS), or risk paying your capital gains tax after all is said and done
1031 Exchange Rules
While this process seems simple enough, the 1031 laws are rigid and do not offer any leeways or grace periods. To avoid any risk, do your homework! Also, consult with a 1031 Exchange real estate expert that can help you navigate the 1031 Exchange process, free from error.
Rules for the Property
One of the 1031 exchange property rules is that properties must be ‘like-kind’, either being used as an investment or for income-generating purposes, to be replaced with similar property of equal or greater value within the US.
An exchange is “like-kind” if your property is being used as an investment or for income-producing purposes, and you replace it with another investment or income-producing property. Real property is generally considered to be of “like-kind” regardless of whether the properties are improved or unimproved, and doesn’t necessarily mean a house for a house.
For example, you may sell a residential duplex and buy a small office complex, or you could sell a warehouse property and opt for a number of single-family rental properties to replace it.
Investment or Business Property Only
A 1031 exchange only applies to property meant for investment or business, not personal property. You may not use one cent of leftover sale proceeds - otherwise known as “boot” - to purchase a primary residence.Greater or Equal Value
If you want to completely avoid paying any taxes on the sale of your property in 1031 exchange, the replacement property must have the same or greater net value as the relinquished property.
Must Not Receive ‘Boot’
In a partial 1031 exchange with a property of lesser value, you would have to pay an amount, or “boot,” as taxes on capital gains. For a complete 1031 exchange, you must not receive any boot to close a tax-free transaction.
Same Tax Payer
The documents of the tax return and deeds for the properties being exchanged must have the name of the same title-holder or taxpayer, with an exception only in case of a limited liability company with a single member.
Rules on Timing
45 Day Identification Window
In this real estate investment, when you close on the sale of your original property, you get 45 calendar days to identify potential replacement properties for the 1031 exchange.
The exception to this rule occurs in the case of the 200% rule.
180 Day Purchase Window
The property exchange must be completed within 180 days or within the due date of your income tax return for the year in which the relinquished property was sold.
Rules on Identification
3-property rule: You may identify three properties of any market value for your 1031 exchange.
200% rule: You may identify an unlimited number of properties as a replacement, with their cumulative value not exceeding 200% of the value of your relinquished property.
95% rule: You may identify any number of properties as long as your acquired properties are valued at 95% or more of their total value.
Types of 1031 Exchange
Simultaneous Exchange: occurs when you close the exchange of properties simultaneously on the same day through a ‘swap’ of deeds between two parties, a third ‘accommodating party’ that facilitates the simultaneous transaction, or structuring the entire transaction by a qualified intermediary. Any delay can disqualify the exchange from tax exemption.
Delayed Exchange: the most commonly chosen exchange where you find a replacement property within 45 days and execute the exchange agreement, and then hire an Exchange Intermediary to initiate the sale of your property and hold the sales proceeds while you acquire a ‘like-kind’ property within 180 days.
Reverse Exchange: or a forward, all-cash exchange that occurs simply through acquiring a replacement property within 45 days before you exchange your relinquished property within another 135 days.
Construction or Improvement Exchange: occurs when you use exchange equity to improve the replacement property within 180 days through a qualified intermediary.
All being said, when it comes to selling a real estate investment, following the rules for a 1031 exchange can ensure the best value for your money and help grow your real estate investment portfolio in the most advantageous way.