The successful consummation of a Section 1031 Exchange requires the taxpayer to follow IRS guidelines that are broad in some respects and specific in others. Some tax advisors refer to 1031 as one of the more generous provisions of the internal revenue code, offering real estate investors an unparalleled chance to preserve and grow wealth by deferring recognition of capital gains. The broad guidelines are the “like-kind” provisions, which accommodate the exchange of many different varieties of commercial investment properties.
Where the code is strict, however, is in adherence to the timelines, which are tight and require diligent attention to meet. Once you enter into a contract to sell the targeted investment property (referred to in the code as the relinquished property), the calendar starts running on the first deadline, which is 45 days. Within that time, you will need to identify replacement property. Identification will be made to the qualified intermediary, who also holds the funds realized from the initial property sale. This point is crucial since the taxpayer may not control those funds.
Identification is a formal process, and the taxpayer has three options from which to select.
- Option 1 allows you to identify up to three properties as prospective purchases, with no restrictions on their individual or combined market price. Keep in mind that if the sale price of the relinquished property is greater than the purchase price of the replacement property or properties, the difference must be recognized as a capital gain.
- Option 2 provides for the consideration of an unlimited number of replacement properties, subject to a limit of the aggregate market value of 200% of the price of the property sold. If the relinquished property is worth $1 million, the seller can identify replacement choices totaling up to $2 million.
- Option 3 allows the taxpayer to specify an unlimited number of properties but requires that he acquire a subtotal equal to at least 95% of their total market price. As an example, Option 3 would allow you to identify ten replacement properties. If the total of their market value all combined is equal to $10 million, you must ultimately purchase some combination of those properties with a purchase price of at least $9.5 million.
The second element of the timeline specifies that the replacement purchase is completed within 180 days of the sale of the relinquished property. That includes the first 45 days provided to identify replacement properties; the clock does not start over after replacement identification. In the instance of a "build-to-suit" exchange, which includes renovation, any improvements must also be completed within the 180 days, which makes them tricky.
Construction, improvement, and other special needs have supported the growth of reverse exchanges, in which you find the replacement property before you sell the relinquished asset. The same timeline applies, but in reverse, and the Qualified Intermediary now serves as the exchange accommodation titleholder. You need to identify the property to exchange within 45 days of acquiring that new property and complete the entire transaction within 180 days.
Extensions to the 45- and 180-day deadlines are only provided by the IRS and generally in response to federally declared disasters, such as hurricanes, wildfires, and other significant events. This spring, the IRS granted extended deadlines for 1031 exchanges due to the Covid-19 impact but allowed the extension to expire in July.