1031 Tax Deferred Exchange
A 1031 Tax-Deferred Exchange is a transaction that allows property owners to preserve the total value of their investment property. A 1031 Exchange will enable owners who decide to dispose of their investment properties to do so and avoid having to pay capital gains taxes by allowing them to reinvest their sales proceeds for “like-kind” properties.
The general rules governing a 1031 Exchange are pretty simple. Any property (real or personal) can be exchanged, provided the relinquished property was previously held for investment purposes. Under most circumstances, a private residence will not qualify as a tax-deferred exchange.
- LIKE-KIND The replacement property must be “like-kind” to the relinquished property. “Like-kind” does not mean precisely the same. The most fundamental property is considered “like-kind” to other tangible property, such as the exchange of a single-family rental home for a condominium, warehouse, or office building.
- PROPERTY VALUE As a rule of thumb, the property you acquire must have both value and equity equal to or greater than the property relinquished.
- IDENTIFICATION PERIOD – The property to be acquired must be identified within 45 days of the closing of the relinquished property. Property identification rules include:
- Three (3) PROPERTY RULE: Up to three (3) properties may be identified, no matter what their value,
- OR 200 PERCENT RULE: Any number of properties may be identified as long as their combined fair market value isn’t more than twice that of the relinquished property
- OR 95 PERCENT RULE: Any number of properties may be identified, regardless of their combined fair market value, as long as you acquire 95% of that total value.
- EXCHANGE PERIOD – The acquisition of the new property must be completed within 180 days of the transfer of the relinquished property or by the filing date of the tax return for the year the first property was transferred. These time restrictions must be strictly followed for the exchange to be allowed by the IRS. The IRS does not grant extensions.
- STEPS INVOLVED IN A SUCCESSFUL EXCHANGE
- Purchase Contract. A contract is executed between the Buyer and Seller to purchase and sell the relinquished property. The purchase contract should contain a “cooperation clause” in which the Buyer agrees to cooperate with the Seller in structuring and completing a 1031 exchange. The Seller (or Buyer) will assign their interest in the agreement to a Facilitator or a Qualified Intermediary (FAC or QI).
- Exchange opened. The exchange is set up with the FAC or QI usually after escrow has been opened for closing the sale. The necessary documentation to affect the business should then be prepared. The Exchange Agreement (between the taxpayer and the FAC or QI) defines the exchange transaction and sets forth the obligations of the taxpayer and FAC or QI. An Assignment of the relinquished property purchase contract to FAC or QI is prepared, assigning the rights as Seller to the FAC or QI.
- Closing the relinquished property. The abandoned property closes when all conditions of sale have been met, and the property is conveyed to the Buyer. While the conveyance will be directly from the Seller to the Buyer, it will represent a transfer from the Seller to the FAC or QI in exchange for other property to be received later. The proceeds from the sale are delivered directly to the FAC or QI for the replacement property. At no time should the Seller be in either actual or constructive receipt of the cash proceeds.
- Identification of replacement property. The period to identify the property (or properties) to be purchased as the replacement property starts on the closing of the relinquished property. Forty-five (45) days from the date of transfer are allowed to identify the acquisition property.
- Purchase Contract for replacement property. After identifying a suitable “like kind”like-kindent property and deciding which property will be acquired, a purchase contract will be entered with the Seller. The property must be one or more of the properties identified by the end of the 45-day identification period.
- Exchange documentation for the acquisition property. The Assignment of the purchase contract for the replacement property and the Release and Warranty to be executed by the Buyer and Seller should then be prepared. Instructions should also be ready for the settlement agent, noting the necessary items to complete the exchange.
- Closing the replacement property. When the closing conditions have been met, the FAC or QI should deliver the funds it has been holding to the settlement agent to acquire the replacement property. The Seller will convey the replacement property directly to the Buyer. The closing of the replacement property must occur within 180 days of the transfer of the relinquished property (or by the tax return due date, if earlier) for the transaction to qualify for Section 1031 treatment.
by Mark Pustka