If you are looking to preserve your real estate wealth without paying hefty capital gains taxes when you sell property, the 1031 exchange may be the perfect tool for you.
Established by the IRS in 1991, it is also known as the “Like Kind Exchange.” In a nutshell, the 1031 exchange allows you to reinvest your financial proceeds from the sale of one property into the purchase of another, without those proceeds being subject to capital gains taxes.
This exchange is allowable for any real property as defined by law in the state in which the property is located. The property must be owned as an investment or for the purpose of producing income.
Most commonly used for real estate, the 1031 exchange could also be utilized for certain personal property or Tenants in Common exchanges. Non-qualifying property includes shares of corporate stock in different companies or exchanges of partnership interests in different partnerships. Even livestock not of the same sex do not qualify for a 1031 exchange.
There are two tax terms used to describe property under this exchange. The Relinquished Property refers to the qualified property you are entering into the exchange (the property being sold). The Replacement Property is the qualified property you are receiving (buying).
In order for a successful 1031 exchange to occur, the property must qualify for non-recognition of gain. There are three conditions which must be met for a property to qualify:
1. The properties must be of “like kind.”
For tax purposes, there are four classifications of real estate: Property held for business use, land held for investments, property held for personal use, and property held primarily for sale. Only the first two types qualify for the 1031 exchange.
2. There must be an actual exchange, not just a transfer of property for money.
Any proceeds from the sale of the relinquished property must be held by a Qualified Intermediary. If the seller of the relinquished property at any time takes actual or constructive control of the proceeds, the 1031 exchange is invalid.
3. Set time requirements must be strictly adhered to.
Within 45 days of the transfer of your relinquished property (essentially, the close of the sale), you must identify in writing your replacement property. One of the following conditions must be satisfied:
The 3-Property Rule – You may identify a maximum of three replacement properties without regard to fair market value of the properties.
The 200 Percent Rule – You may identify any number of properties as long as their combined fair market value does not exceed 200 percent of that of the relinquished property.
The 95 Percent Rule – You may receive any number of properties as long as the fair market value of any properties actually received during the exchange is at least 95% of the fair market value of all identified potential replacement properties.
A 1031 exchange begins upon the recording of the deed of the relinquished property or when the proceeds have been received by a Qualified Intermediary and have been deposited into a secured account. The replacement properties, as stated above, must be identified within 45 days, and the entire exchange must be complete within 180 days.
Remember, the replacement property must have a fair market value equal to or greater than the adjusted sales price of the relinquished property. In short, all proceeds from the sale of the relinquished property must be reinvested in the replacement property.
Replacement property is identified as such only if it is so designated, in a written document signed by you. This document must be delivered to another person involved in the exchange – such as the Qualified Intermediary or the seller of the replacement property – either by hand, mail, or fax before the end of the identification period. Identified replacement property can also be revoked if done in writing before the end of the 45 day identification period.
As long as the transaction to acquire the replacement property is completed within the 180 day exchange period, and as long as the replacement property actually acquired is substantially the same as that which was identified during the 45 day identification period, the property is considered received.
New construction or property that is partially completed can qualify for the 1031 exchange as long as it is properly identified.
If you are considering entering into a 1031 exchange, you should employ the services of your accountant or tax attorney and ensure all tax implications have been taken into consideration. Once you have determined that this is the most favorable option for you, and your property meets the requirements for this type of transaction, list the property for sale.
There must be a “Cooperation Clause” written into the sales agreement for the relinquished property. It informs the buyer that you intend to complete a 1031 exchange and states the buyer will agree to cooperate with the seller in accomplishing it without further cost to the buyer. Your agent or escrow officer should contact a Qualified Intermediary to order the appropriate documents.
You will then enter into an agreement with the Qualified Intermediary, in which he or she will be named as the principal in the sale of your property. The Qualified Intermediary will also be the principal in the purchase of the replacement property. Escrow will be amended to reflect this.
Once escrow has closed, the Qualified Intermediary will deposit the funds received in a separate, secured account. This is when the clock begins for the 1031 exchange time limits.
Within 45 days, written identification of the intended replacement property must be sent to the Qualified Intermediary, signed by everyone who signed the exchange agreement. Delivery by certified mail to the Qualified Intermediary or the seller of the replacement property ensures proof of receipt of the letter. It may also be delivered by hand, by fax, or by regular mail service.
Once you have identified the replacement property you enter into a written agreement to purchase it. The Qualified Intermediary is named in the escrow instructions as the buyer, and the “Cooperation Clause” needs to be included.
Escrow on the replacement property must close within 180 days of the initial deposit of funds, with the final closing statement listing the Qualified Intermediary as the buyer. When the property is deeded, it will be deeded from the true seller to the true buyer.
When income taxes are due following the completion of a 1031 exchange, you must file form 8824 with the IRS, in addition to any forms required by your state of residence. In order for the procedure to be valid, it must follow IRS guidelines exactly, particularly in regard to the handling of the proceeds.
If, in the process of conducting a real estate exchange, you receive cash as a result of the transaction, it does not necessarily negate the 1031 exchange. An example would be if you relinquished a property with a mortgage of $150,000 that was assumed by the buyer. This would be considered a cash gain, or “boot,” in your favor and would be taxable.
If you then acquired a replacement property and assumed a mortgage of $130,000 on the new property, your net “boot” would be $20,000. You would be responsible for taxes on that net amount.
There are many other specific instructions that must be followed when executing a 1031 exchange, depending largely on the type of property being entered into it. Be sure to enlist the aid of a highly qualified tax attorney or accountant to help you through the process. Remember, if the specifications are not followed exactly, the 1031 exchange will be deemed invalid and all proceeds will then be taxed as a cash gain.