If you’ve looked online, you know there is a great deal of information about the 1031 exchange process. Relinquishing investment real estate into “like-kind” real property can help defer capital gains taxes.
But the 26 U.S. Code § 1031 – “Exchange of Real Property Held for Productive Use or Investment” – has several must-adhere-to rules to ensure a valid transaction and to avoid an unanticipated tax bill. Many of those rules—such as the following—are specific to replacement properties as part of the exchange.
Deadlines are in Stone
The IRS is adamant when it comes to 1031 exchange dates for replacement properties. Specifically:
- Your replacement property/properties must be identified within 45 days of your relinquished property closing.
- You must purchase that replacement property/properties within 180 days of closing on your relinquished property.
Keep in mind that these are calendar days, which include weekends and holidays. If the 45-day identification deadline falls on a Saturday, your replacement property/properties must be identified and documented by then. If the 180-day purchase deadline falls on New Year’s Day, you must close on your replacement property/properties no later than January 1 (preferably beforehand). Failure to adhere to these deadlines means you could lose out on any tax-deferred benefits.
You MUST Use a Qualified Intermediary
Another issue regarding the like-kind exchange is that you aren’t allowed to handle any proceeds from buying or selling properties. This is where the Qualified Intermediary (QI) comes into play.
The QI (sometimes known as an Accommodator) holds cash from the sale of the relinquished property, then uses it to purchase your replacement property. The QI also handles documentation and paperwork involved with a 1031 exchange.
Value and Price Matter
The replacement property/properties you select must be of equal or greater value than your relinquished property. You have three choices here:
- Identify up to three replacement properties, any of which are of equal or greater value to your relinquished property.
- Identify as many properties as you want, as long as their combined value doesn’t exceed 200% of your relinquished property’s value.
- Identify as many properties as you want, as long as the assets you end up buying are valued at 95% or more of your relinquished property’s value.
Like-Kind Means “Real”
At one time, it was possible to exchange any kind of capital asset used for business or investment into another like-kind asset to defer capital gains taxes. However, passages of the Tax Cuts and Jobs Act of 2018 excluded tangible personal property under the 1031 exchange rules.
The only replacement property/properties eligible for exchange under the 1031 rules is real estate specifically used for purposes of trade or investment. But your replacement property doesn’t have to be the same as the real asset you’re relinquishing. You could exchange an office building for an industrial warehouse, or an apartment complex for a retail strip center.
You could also exchange tangible real estate into a Delaware Statutory Trust (DST). In some cases, real estate investment trusts (REITs) can be used as replacement properties, but the process here is very complex.
When in Doubt . . .
In closing, the 1031 exchange process is useful for deferring capital gains taxes on the sale of real estate. But failure to identify the correct replacement property could make the exchange process valid. As such, it’s essential to work with knowledgeable professionals to ensure your like-kind exchange process proceeds smoothly.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor.
There is no guarantee that the investment objectives of any particular program will be achieved.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
All real estate investments have the potential to lose value during the life of the investment.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor returns and may outweigh tax benefits.