If you know anything about the IRS, it’s that they love making rules. Unfortunately for most of us, they don’t always make them easy to understand. A 1031 exchange is a major financial transaction for most investors, and given the consequences, one where you want to play by the rules. Let’s break down the key 1031 exchange rules in layman’s terms:
45-Day Identification Period. You must identify potential replacement properties within 45 calendar days from the time you sell your property.
180-Day Closing Period. You must complete the purchase of a new property or properties within 180 calendar days from the time you sell your property. The 45-day and 180-day time periods start at the same time -- you do NOT get 180 days after identifying properties. To make matters a bit more complicated, there is a caveat to this rule. Technically, you must close on the new property the earlier of a) 180 calendar days or b) the due date for filing your tax return for the year in which the property was sold. Talk to your accountant early on to understand your dates and possible filing extensions.
Report your Exchange. You must report your exchange to the IRS in the year in which you sold your property. The IRS provides a special form to do this (IRS Form 8824) and it must be included with your tax return for that year. Have your accountant help you.
Identification Options. We just mentioned that you have 45 days to identify potential properties for your exchange. That may seem like a tight timeframe to find the right fit. Fortunately, the IRS allows you to identify more than one possible property according to one of the following rules:
- Three Property Rule: Most investors use this option. You may identify up to three potential replacement properties. While you are allowed to acquire all three of the identified properties as part of your exchange, most investors focus on acquiring one of the three and use the second and third identified properties as backups in case they cannot acquire the first property.
- 200% Rule: You may identify more than three potential replacement properties as long as their combined value (purchase price) is less than 200% of the sale price of the relinquished property (the one you just sold).
- 95% Rule: You may identify any number of properties without regard to prices as long as you actually purchase 95% of the value you identify. Be careful: If you acquire even a small amount less than 95%, you might disqualify your entire transaction! As you may have guessed, this option is seldom used in practice.
Report your Identified Properties. You must formally identify your potential replacement properties. Identification needs to be:
- In writing. Potential replacement properties must be clearly identified -- the more specific, the better. We recommend including the property address, legal description (if available) and parcel number or tax ID number.
- Signed by you.
- Delivered to the Seller of the potential replacement property and/or your Qualified Intermediary (“QI”). Notice to your attorney, real estate agent, accountant or anyone else does NOT qualify as proper identification.
- There is not a specific identification form required by the IRS, but an experienced Qualified Intermediary should be able to provide you with one.
- Special note: Many of the opportunities you will find on the Realized Marketplace are Replacement Property Interests™ which represent equity ownership in large properties with multiple 1031 exchange investors. If you are identifying a Replacement Property Interest™, you must include the exact percentage you are considering in your identification. We’re happy to help you with this.
Purchase Price. The purchase price of your replacement property must be equal to or greater than the sale price of your relinquished property.
Mortgage Balance. Likewise, the mortgage amount on your replacement property must equal or exceed the mortgage balance you paid off when selling your relinquished property.
Buy what you identified. You must purchase a property (or properties) that is substantially the same as what you identified.
Don’t Touch the Cash! The IRS requires the use of a Qualified Intermediary to complete a 1031 exchange. Your QI must hold your proceeds during your exchange. You may not receive, or have direct access to, your proceeds in any way during the exchange process. For instance, having the funds in your bank account, even if you do not make a withdrawal, is prohibited.
Same Taxpayer. You must acquire the replacement property under the same legal entity that was the seller of your relinquished property. If you bought your previous property in your own name, you need to acquire the replacement property in your own name. If you bought your previous property using an LLC or trust, you need to use the same LLC or trust to purchase the replacement property.
Failure to follow the rules may result in the transaction being treated as a taxable sale rather than a tax-deferred exchange. Plan ahead to avoid this. Your accountant, attorney, and QI are all on your team. Consult your advisors early and often!