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The 1031 Exchange Rules
The rules are quite clear, detailed and uncomplicated; however, you must follow them - with no exceptions.
Here is a summary of the 1031 Exchange rules
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- All relinquished (old) and replacement (new) property must be vacant land, rental property or property used for trade, business or investment.
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- The property must be held for at least a year and a day to qualify for a 1031 Exchange.
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- If the properties meet these requirements, you may exchange any real estate for any other type of real estate.
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- You cannot have actual or constructive control of any of the proceeds received from the sale of the old property.
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- By law, all money must be held by a Qualified Intermediary (also referred to as an Accommodator or Facilitator). You cannot have an associate or employee, your attorney, broker or CPA hold the proceeds, nor can you leave the proceeds in escrow until the second property is purchased.
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- You have 45 calendar days from the date of closing on the old property to identify a list of properties, from which you will purchase the new property.
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- From the date of closing, you have 180 calendar days to close on one or more of the properties from your 45-day list.
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- The titleholder on the old property must be the same titleholder on the new property.
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- You must reinvest all cash proceeds from the sale, and purchase a new property or properties of equal or greater value, in order to avoid taxation on the gains. *
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The tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, offers investors one of the last great opportunities to build wealth and save taxes. By completing an exchange, the investor (Exchanger) can dispose of their investment property, defer the capital gain tax that would ordinarily be paid and leverage all of their equity into a replacement property.
1031 Exchange Requirements
Two requirements must be met to defer the capital gain tax: (a) the Exchanger must acquire “like kind” replacement property and (b) the Exchanger cannot receive cash or other benefits (unless the Exchanger pays capital gains taxes on this money). In any exchange the Exchanger must enter into the exchange transaction prior to the close of the relinquished property. The Exchanger and the Qualified Intermediary enter into an Exchange Agreement, which essentially requires that (a) the Qualified Intermediary acquires the relinquished property from the Exchanger and transfers it to the buyer by direct deed from the Exchanger and (b) the Qualified Intermediary acquires the replacement property from the seller and transfers it to the Exchanger by direct deed from the seller. The cash or other proceeds from the relinquished property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary in a separate, secure account. The exchange funds are used by the Qualified Intermediary to purchase the replacement property for the Exchanger.
1031 Exchange Considerations
- Exchanges must be completed within strict time limits. The Exchanger has 45 days from the date the relinquished property closes to “Identify” potential replacement properties. This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement properties. The purchase of the replacement property must be completed within 180 days after of the close of the relinquished property. After the 45 days has passed, the Exchanger may not change their Property Identification list and must purchase one of the listed replacement properties or the exchange fails!
- To avoid the payment of capital gain taxes the Exchanger should follow three general rules: (a) purchase a replacement property that is the same or greater value as the relinquished property, (b) reinvest all of the exchange equity into the replacement property and (c) obtain the same or greater debt on the replacement property as on the relinquished property. The Exchanger can offset the amount of debt obtained on the replacement property by putting the equivalent amount of additional cash into the exchange.*
- The Exchanger must sell property that is held for income or investment purposes and acquire replacement property that will be held for income or investment purposes.
- IRC Section 1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interests, or interests in a partnership.
- 1031 Exchange rules may change.
*Taxes may be owed on amounts not reinvested in like kind property.
The full IRS code may be found at www.irs.gov.
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