1031 Exchange Overview

A 1031 tax-deferred exchange enables an investor to reinvest the proceeds from the sale of investment property in one or more replacement properties without incurring immediate federal (and most state) capital gains taxes on the appreciated value. When the sale and purchase meet the 1031 exchange criteria, taxes are deferred until the newly acquired property is sold. This deferral strategy can be repeated through any number of exchanges until the tax liability passes into the individual’s estate upon death. A 1031 exchange can be an effective tool for building wealth.

Section 1031 Requirements
Replacement property acquired in a 1031 tax deferred exchange must be “like-kind” to the property being sold. Like kind means “similar in nature or character, notwithstanding differences in grade or quality.” In order for the properties to qualify as “like-kind” they must be held for productive use in a trade or business or held for investment purposes.

A 1031 exchange may involve any of the following property types:

APARTMENT

OFFICE

RETAIL

INDUSTRIAL

HOSPITALITY

SENIOR HOUSING

OIL & GAS 

1031 exchanges are subject to the various restrictions set forth in Section 1031 of the Tax Code.  The general guidelines to follow in order for a taxpayer to defer all the taxable gain are as follows:

• The value of the replacement property must be equal to or greater than the value of the relinquished property.
• The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
• The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
• All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.

There are strict timeline and identification rules that must be followed for a 1031 exchange. First, the investor must identify replacement property within 45 calendar days of the close on the relinquished property. This identification must be in writing and can follow one of three possible identification rules:

3-PROPERTY RULE: Up to three properties are identified no matter what value.

 200% RULE: Any number of properties are identified as long as their combined fair market value (FMV) does not exceed 200% of the FMV of the relinquished properties.

95% RULE: Any number of properties are identified no matter what the aggregate FMV, provided 95% of the value of the identified properties is acquired.

Second, the investor must close on the identified replacement property(s) within 180 days from the close date of the relinquished property.

The Role of a Qualified Intermediary
Moreover, an independent third party must serve as a Qualified Intermediary (QI). The QI is required to hold the proceeds of the sale of the relinquished property until the proceeds are reinvested. There must also be a written “exchange agreement” between the investor and the QI, which serves to protect the investor from having “constructive receipt” of the exchange funds during the exchange period. The QI’s role is to ensure these rules are properly followed and that the equity is preserved. IRS rules require the investor to have a QI to complete a 1031 exchange. We work with QI’s from coast to coast. If you need a QI in your local area, just give us a call.

Investors must work with their professional tax advisor to meet the requirements of IRC Section 1031, as failure to comply with IRC Section 1031 or an unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities, including tax penalties.  Furthermore, fees and expenses associated with Tenant-In-Common may outweigh the benefits of tax deferral.