1031 Exchanges

Have you been thinking about a 1031 Exchange with your real estate? This page gives you the basics about your interests in tax deferment of your real estate. If you have specific property questions about 1031 Exchanges for Summit County, CONTACT ME for assistance any time.

What is a 1031 Exchange? (simple)

In layman terms, a 1031 Exchange allows a property seller to temporarily not pay, or defer, capital gains taxes on the sale of their property as long as the seller buys a property of “like-kind” within 6 months. There are specific rules to follow in order to realize this tax deferment, and there is a small fee, but a 1031 Exchange is a wonderful and common tax option for property sellers throughout the United States. For more detailed information on the rules of 1031 Exchanges, read the following information.

What is a 1031 Exchange? (in detail)

A 1031 exchange is simply a method by which a real property owner disposes of one property and acquires another without having to pay any capital gains tax on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. In an exchange, the tax on the exchange is deferred indefinitely.

1031 exchanges are authorized by Section 1031 of the Internal Revenue Code. Careful adherence to the requirements of Section 1031 is important in maintaining the tax-free status of the transaction. The sale of the relinquished property and the subsequent reinvestment in a replacement property can qualify as a trade or exchange by means of an exchange agreement and the services of a qualified intermediary (see 1031 intermediary). An intermediary can guide you through the IRS’s regulations, making a 1031 exchange easy, inexpensive, and safe. You should also consider having your accountant and/or attorney review any real estate transaction.

What is a Reverse 1031 Exchange?

A “reverse” exchange is the “flip side” of a deferred (delayed) exchange. In a “reverse” exchange, the Exchanger acquires the like-kind replacement property before disposing of a relinquished property. Until very recently, it was unclear whether reverse exchanges would be given non-recognition treatment by the IRS. However, on September 15, 2000, this question was answered by the IRS in the form of Revenue Procedure 2000-37 (”Rev. Proc. 2000-37″). This Revenue Procedure provides that tax deferral on reverse exchanges will be recognized if the transactions fall within the scope of an announced IRC § 1031 “safe harbor.”

What qualifies as an exchange property “Like Kind Properties”?

In order to qualify for tax deferred exchange treatment under IRC § 1031, the relinquished property must be exchanged for replacement property that is of “like-kind”. This term, “like-kind”, refers to the character of the property and not to its grade or quality. It does not matter whether the real property involved is improved or unimproved since that fact only relates to the grade or quality of the property and not to its kind or class. (Treas. Reg. § 1.1031(a)-1(b)).

Essentially, all real property is “like-kind” with all other real property. To qualify, the Exchanger must have held the relinquished property for investment, or for “productive use in their trade or business,” and must intend to do the same with the replacement property.

  • Any property held for the productive use in a trade or business or for investment, such as an apartment building, equipment, raw land or shopping center.
  • Section 1031 excludes certain property such as stocks, bonds, partnership interests and stock in trade (i.e. inventory).

What must I do to receive tax-deferred treatment for my 1031 exchange?

  • An investor must (1) acquire replacement property equal to or greater in value than the relinquished property; (2) the equity in the replacement property must be equal to or greater than the equity in the relinquished property; and (3) all net proceeds must be used in acquiring replacement property.

What are the rules for identification of an exchange property?

The 45-Day Rule for Identification.

The first timing restriction for a delayed Section 1031 exchange is for the taxpayer to either close on Replacement Property or to identify the potential Replacement Property within 45 days from the date of transfer of the exchanged property. The 45-Day Rule is satisfied if replacement property is received before 45 days has expired. Otherwise, the identification must be by written document (the identification notice) signed by the taxpayer and hand-delivered, mailed, faxed, or otherwise sent to the Intermediary. The identification notice must contain an unambiguous description of the replacement property. This includes, in the case of real property, the legal description, street address or a distinguishable name.

After 45 days, limitations are imposed on the number of potential Replacement Properties which can be received as Replacement Properties. More than one potential replacement property can be identified under one of the following three conditions:

  • The Three-Property Rule - Any three properties regardless of their market values.
  • The 200% Rule - Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the exchanged properties as of the initial transfer date.
  • The 95% Rule - Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.

Although the Regulations only require written notification within 45 days, it is recommended practice for a solid contract to be in place by the end of the 45-day period. Otherwise, a taxpayer may find himself unable to close on any of the properties which are identified under the 45-day letter. After 45 days have expired, it is not possible to close on any other property which was not identified in the 45-day letter. Failure to submit the 45-Day Letter causes the Exchange Agreement to terminate and the Intermediary will disburse all unused funds in his possession to the taxpayer.

  • The 180-Day Rule for Receipt of Replacement Property. The replacement property must be received and Exchange completed no later than the earlier of 180 days after the transfer of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the exchanged property was transferred. The replacement property received must be substantially the same as the property which was identified under the 45-day rule described above. There is no provision for extension of the 180 days for any circumstance or hardship.

As noted above, the 180-Day Rule is shortened to the due date of a tax return if the tax return is not put on extension. For instance, if an Exchange commences late in the tax year, the 180 days can be later than the April 15 filing date of the return. If the Exchange is not complete by the time for filing the return, the return must be put on extension. Failure to put the return on extension can cause the replacement period for the Exchange to end on the due date of the return. This can be a trap for the unwary.