For investors intent on benefitting from the substantial advantages available through strategic employment of Section 1031 of the Internal Revenue Code, timing is critical. The foundation of the 1031 exchange is the concept that when an investor uses the proceeds of a property sale to purchase another property, the investor is, in effect, continuing the investment. Because the taxpayer is reinvesting all the profits, the IRS doesn't require payment of taxes on cash the taxpayer didn't receive. The investor should be aware that the tax is deferred, not eradicated. That means that if the taxpayer later sells a property without exchanging it for another qualified “like-kind” investment as a replacement, they will owe taxes on the accumulated gains.
History buffs may be aware that when Congress adopted the first income tax provisions in 1918, it did not include any deferred exchange structure. However, the Revenue Act of 1921 included a section allowing for exchanges (like-kind and non-like-kind) to provide taxpayer relief through deferral of taxes to encourage investment. It wasn't until after the Starker case in 1979 (in which the Ninth Circuit ruled that delayed exchanges were qualified) that the IRS recognized the need for added structure to manage the exchange process. In response, Congress passed the Deficit Reduction Act of 1984, which established the 45-day replacement property identification window and the 180-day total limit for exchanges to be transacted.
Because those deadlines are short and strict, it is vital that the investor enter the original property's sale with a plan already formed. If you inadvertently take possession of the proceeds of the relinquished property's sale (rather than directing them to a Qualified Intermediary), you will lose the ability to complete a 1031 exchange. If that happens, you are leaving money on the table (or sending it to the IRS) that you could have used for your next purchase. Similarly, if you fail to identify potential replacement property within 45 days, again, you will lose the opportunity to complete the exchange.
Keep in mind that there are three options for replacement property identification:
Option 1 allows you to identify up to three properties as prospective purchases, with no restrictions on their individual or combined market price. If the sale price of the relinquished property is greater than the replacement property or properties' purchase price, you must recognize the difference as a capital gain.
Option 2 provides for you to consider an unlimited number of replacement properties, subject to a limit of the aggregate market value of 200% of the price of the property sold.
Option 3 allows you to specify an unlimited number of properties but requires that you acquire a subtotal equal to at least 95% of their total market price.
Finally, if you cannot complete the replacement purchase within the 180-day timeframe, the transaction will not be qualified. In any of these instances, the taxpayer's intent to replace the asset with a like-kind property may be in place, but the requirements are not fully satisfied, and the proceeds from the sale will be taxable. In that case, the investor sacrifices the opportunity to use those funds in further pursuit of their investment goals.