What is a 1031 Exchange?
A 1031 tax-deferred exchange enables investors to reinvest the proceeds from the sale of investment property in one or more replacement properties without incurring immediate federal (and most state) capital gains taxes on the appreciated value*. When the sale and purchase meet the 1031 exchange criteria, taxes are deferred until the newly acquired property is sold. This deferral strategy can be repeated through any number of exchanges until the tax liability passes into the individual’s estate upon death.
Section 1031 Requirements
Replacement property acquired in a 1031 tax deferred exchange must be “like-kind” to the property being sold. Like-kind means “similar in nature or character, notwithstanding differences in grade or quality.” In order for the properties to qualify as “like-kind” they must be held for productive use in a trade or business or held for investment purposes. A 1031 exchange may involve any of the following property types:
- Single Family Rentals
- Multi-Family Rentals
- Office Buildings
- Storage Facilities
- Raw Land
- Retail Shopping Centers
- Industrial Facilities
The general guidelines to follow in order for a taxpayer to defer all the taxable gain are as follows:
- The value of the replacement property must be equal to or greater than the value of the relinquished property.
- The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
- The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
- All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
There are strict timeline and identification rules that must be followed for a 1031 exchange.
First, the investor must identify replacement property within 45 calendar days of the close on the relinquished property. This identification must be in writing, and can follow one of three possible identification rules:
3-property rule: Up to three properties are identified no matter what their value.
200 percent rule: Any number of properties is identified as long as their combined fair market value (FMV) does not exceed 200% of the FMV of the relinquished properties.
95 percent rule: Any number of properties are identified no matter what the aggregate FMV, provided 95% of the value of the identified properties is acquired.
Second, the investor must close on the identified replacement property(s) within 180 days from the close date of the relinquished property.
Moreover, an independent third party must serve as a Qualified Intermediary (QI). The QI is required to hold the proceeds of the sale of the relinquished property until the proceeds are reinvested. There must also be a written “exchange agreement” between the investor and the QI which serves to protect the investor from having “constructive receipt” of the exchange funds during the exchange period. The QI’s role is to ensure these rules are properly followed and that the equity is preserved. IRC rules require the investor to have a QI to complete a 1031 exchange.
A 1031 exchange can be an effective tool for building wealth. However, investors must work with their professional tax advisor to meet the requirements of IRC Section 1031, as failure to comply with IRC Section 1031 or an unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities, including tax penalties.*
*The contents of this site constitute neither an offer to sell nor a solicitation of an offer to buy any security which can only be made by prospectus. Investing in real estate and 1031 exchange replacement properties may not be suitable for all investors and may involve significant risks. These risks include, but are not limited to, lack of liquidity, limited transferability, conflicts of interest and real estate fluctuations based upon a number of factors, which may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment. Neither Everspire, nor DFPG provide tax or legal advice, as such advice can only be provided by a qualified tax or legal professional, who all investors should consult prior to making any investment decision.
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