The 1031 concept itself is simple: Reinvest the proceeds from the sale of a business or investment property into a like-kind investment in order to defer paying capital gains tax.
How does a 1031 exchange work? Say, for instance, you buy a property for $200,000 that is worth $500,000 by the time you sell it down the road.
Rather than paying capital gains on the $300,000 the house has appreciated, a 1031 exchange would allow you to reinvest the proceeds from the sale into another piece of real estate.
Seems simple enough, right? Well, in reality, 1031 exchanges are much more complex. Section 1031 of the Internal Revenue Code (hence the name) has many nuances that can be confusing. There are very specific guidelines governing the process. Here’s a brief overview of what you need to know about a typical 1031 exchange process.
The 3 Types of 1031 Exchanges
Deferred or Delayed 1031 Exchange
This is the most common type of 1031 exchange. In this case, the investor closes on the relinquished property; then, within 45 days (the “identification period”), they identify a replacement property. In order for a replacement property to be considered valid, one of three criteria must be true:
Three Property Rule: An investor identifies up to three different properties as potential purchases within the 45-day identification period, regardless of the total fair market value of the properties.
200% Rule: An investor may identify an unlimited number of replacement properties, as long as the total fair market value of all properties does not exceed 200% of the value of the relinquished property.
95% Rule: An investor may identify as many exchange properties as they want, as long as they receive at least 95% of the value of all identified replacement properties before the end of the exchange period.
In addition to the 45-day identification period, an investor only has 180 days from when they close on the relinquished property to close on the replacement property (the “exchange period”). These two dates are critical for investors to remember.
Finally, this type of 1031 exchange requires investors to use a Qualified Intermediary, also known as an “accommodator.” A QI is an uninvolved third party who holds the investor’s sales proceeds from the sale of their relinquished property in an escrow account until they close on the replacement property. If an investor were to touch the sales proceeds before closing on the replacement property, they would be in violation of Section 1031 and could be held liable for the taxes owed on those proceeds.
Simultaneous 1031 Exchange
The investor closes on the relinquished property, then closes on the replacement property immediately thereafter—usually within one day. An investor may use a Qualified Intermediary to handle the funds, but they’re not required to.
1031 Exchanges: Rules to Keep in Mind
As a general rule of thumb, investors should remember that the replacement property must be of equal or greater value (net of closing costs) than the relinquished property, and all exchange equity must be reinvested for the full tax deferral. To put it simply: trade up.
WHAT INFORMATION IS NEEDED TO STRUCTURE AN EXCHANGE?
Typically the only information we require in order to structure your exchange is the following:
· The Exchangor’s name, address and phone number
· The escrow officer’s name, address, phone number and escrow number
With this said, the following is a list of information we would like to have in order to thoroughly review your intended exchange:
1. What is being relinquished?
When was the property acquired?
What was the cost?
How is it vested?
How was the property used during the time of ownership?
Is there a sale pending? If so, what is the closing date?
Who is closing the sale?
What are the value, equity and mortgage of the property?
2. What would you like to acquire?
What would the purchase price, equity and mortgage be?
If a purchase is pending, who is handling the escrow?
How is the property to be vested?
IS IT POSSIBLE TO EXCHANGE OUT OF ONE PROPERTY AND INTO MULTIPLE PROPERTIES?
It does not matter how many properties you are exchanging in or out of (1 property into 5, or 3 properties into 2) as long as you go across or up in value, equity and mortgage. The only concern with exchanging into more than three properties is working within the time and identification restraints of section 1031.
Choose a company and an exchange representative that:
Is experienced, knowledgeable and can communicate clearly with you, not an assistant who is just filling in a form. The exchange process often requires you to make quick decisions. To do this you’ll want a facilitator who can help you to clearly understand the situation and your options.
Is a full time exchange facilitator. 1031 exchanging is a specialized area of the tax code. To best serve exchangers a facilitator must keep up to date with tax code changes as well as rulings. The 1031 code has a lot of gray areas which an experienced facilitator can help you understand as they apply to your situation.
Is an active member of the Federation of Exchange Accommodators (FEA), www.1031.org. The national association for facilitators. This is the industry’s primary source of tax law information, education and updates, and lobbying activities.
Maintains a substantial fidelity bond for the benefit of their exchangers.
Offers several options for the safe-keeping of your funds during the transaction.
Provides an estimate for services in advance.