1031 Exchange Information
What is a 1031 Tax–Deferred Exchange?
Section 1031 of the Internal Revenue Code relates to Tax Deferred Exchanges. A 1031 tax deferred property exchange is one of the most powerful tax deferral strategies remaining available for taxpayers. It is an exchange of property in which capital gains tax deferral is available to real estate owners who sell their investment, rental, business or vacation real estate, and reinvest the net proceeds in other like kind real estate. The real estate held for these purposes are called like-kind/1031 properties.
The requirements of Internal Revenue Code (IRC) 1031 exchange are met to defer taxes on the profits when a property owner sells like-kind properties and buys replacement properties of like-kind within a specific time period.
What is the Purpose of a 1031 Exchange?
A successful exchange results in the taxpayer being able to utilize 100% of the proceeds from the sale of property to purchase a new property(ies) thereby deferring the capital gains. A 1031 tax deferred exchange allows you to roll-over all of the proceeds received from the sale of an investment property into the purchase of one or more other like-kind investment properties. At closing, proceeds are transferred to a third party--called a facilitator or qualified intermediary--who holds them until they are used acquire the new property. A 1031 exchange allows you defer your taxes as long as you put the money into another property. This means you have more money to use as a down payment to buy an even bigger property, and more monthly spendable income. A 1031 exchanges is more flexible than many people realize. For instance, you can do a "multi-property exchange", where you sell a bunch of small properties and buy a single big one.
What type of properties are potentially eligible
for a 1031 Tax-Deferred Exchange?
There are 5 tax classes of property:
· Property used in taxpayer’s trade or business.
· Property held primarily for sale to customers.
· Property which is used as your principal residence.
· Property held for investment.
· Property used as a vacation home.
Property Which Does Not Qualify For A 1031 Exchange includes:
· A personal residence
· Land under development
· Construction or fix/flips for resale
· Property purchased for resale
· Inventory property
· Corporation common stock
· Bonds
· Notes
· Partnership interests
What Types of Exchanges are Possible?
· Simultaneous Exchange: This occurs when two properties are exchanged simultaneously. This can happen when two properties are swapped, property for property, which is called a two-party exchange. This can also happen when a property is sold and the replacement property is purchased simultaneously.
· Forward Delayed Exchange: This is the most common type of exchange, the Forward Delayed Exchange, happens when a property is sold (Relinquished property) and another property is purchased (replacement property) within 180 days following the sale of the Relinquished Property.
· Construction Exchange: Construction Exchanges, or Build-to-Suit Exchanges, occur when the investor/buyer uses the funds from the sale of the Relinquished Property to construct improvements on the Replacement Property. The property on which the improvements are constructed cannot be held by the taxpayer but must be held by a third party called an Exchange Accommodation Title Holder until either the improvements are complete or until the end of the 180 Exchange Period, after which the title holder is deeded the Replacement Property with the improvements.
· Reverse Exchange: In a Reverse Exchange, the Replacement Property is purchased before the sale of the Relinquished Property. The Replacement Property must be held by an Exchange Accommodation Title Holder until the sale of the Relinquished Property, which must take place within 180 days following the purchase of the Replacement Property.
What are the 1031 exchange restrictions?
· The real property the investor sells and the real property the investor buys must both be held for productive use in a trade or business or for investment purposes and must be like-kind.
· The proceeds from the sale must be managed by a qualified intermediary. They can not be handled by the real estate investor directly or all the proceeds will become taxable.
· All the cash proceeds from the original sale must be reinvested in the replacement property - any cash proceeds that the investor retains will be taxable.
· The replacement property must be subject to an equal level or greater level of debt than the relinquished property or the buyer will either have to pay taxes on the amount of the decrease or have to put in additional cash funds to offset the lower level of debt in the replacement property.
A Qualified Intermediary (QI) is required for all 1031 Tax Exchanges.
To ensure safe harbor protection, a Qualified Intermediary should facilitate the exchange. The QI is a 1031 exchange Intermediary or entity that can legally hold funds to facilitate a 1031 exchange. The use of a Qualified 1031 Exchange Intermediary is essential to successfully completing the 1031 exchange process. The QI performs several important functions in the 1031 exchange process including creating the exchange of properties, holding the 1031 exchange proceeds and preparing the legal documents. The IRS will not allow the investor to receive cash proceeds or take "constructive receipt" of the funds in any way, or else he or she will be taxed.
How is Replacement Property Identified?
· 3-property rule: The Exchanger may identify up to three properties without regard to their value. More than 95% of exchanges use the 3-property rule.
· 200% rule: The Exchanger may identify any number of properties as possible replacements for your relinquished property as long as the aggregate value of those properties does not exceed 200% of the value of your relinquished property.
· 95% exemption: The Exchanger may identify any number of properties as possible replacements for your relinquished property, without regard to their value, as long as the Exchanger ends up purchasing at least 95% of the aggregate value of all properties identified.
What are the time period limitations for a 1031 Tax Exchange?
· Identification Period: Within 45 days of selling the relinquished property the investor must identify suitable replacement properties. This 45 day rule is very strict and is not extended should the 45th day fall on a Saturday, Sunday, or legal holiday.
· Exchange Period: The replacement property must be received by the taxpayer within the "exchange period," which ends within the earlier of . . . 180 days after the date on which the taxpayer transfers the property relinquished, or . . . the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. This 180-day rule is very strict and is not extended if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.
The Key Steps in a 1031 Tax Deferred Exchange:
Before you begin the exchange process, be sure to consult with your tax or financial advisor to ensure that a 1031 exchange is right for you. Your Exchange Coordinator will lead you through the process, answering your questions and providing guidance along the way.
Sale of the Relinquished Property
Before the sale of the first property (Relinquished Property) the Exchanger must complete the needed documentations. At closing, the proceeds are delivered directly to the Qualified Intermediary.
Identification of Replacement Property
The Exchanger must identify the property to be purchased (Replacement Property) within 45 days following the sale of the Relinquished Property. The taxpayer may generally identify up to three properties as potential Replacement Property(ies).
Purchase of the Replacement Property
The Exchanger must obtain the Replacement Property within 180 days following the sale of the Relinquished Property, which must be identified property. At closing, the proceeds are paid directly by the Qualified Intermediary, and the Exchanger receives the Deed to the Replacement Property.
