Executing a successful 1031 exchange requires taxpayers to follow strict process rules or risk that the IRS won't allow the transaction. The result of a failed exchange can be an unexpected and unwelcome capital gains tax bill, so investors should proceed carefully.
The IRS guidelines for a 1031 are broad in some respects and specific in others. Some tax advisors refer to Section 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 various commercial investment properties. For example, an investor can exchange a rental house for an office building or farmland for a self-storage facility. However, the property must be part of a business or otherwise held for investment purposes. For example, it can't be a personal residence or a home bought for flipping.
While the nature of the replacement property is flexible, the timeline for doing so is not. The code is strict in both the time allowed and the process for identifying potential replacements for the asset being sold (referred to as the “relinquished” property).
Once the investor enters a contract to sell the targeted investment property, the calendar starts running on the first deadline, which is 45 days. Within that time, they need to identify replacement property. Identification is a formal process of communicating potential acquisition options to the qualified intermediary, who also holds the funds from the initial property sale. This point is crucial since the taxpayer is prohibited from accessing those funds.
Option 1 allows the investor 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. The replacement purchase must also carry an equal debt load.
Option 2 allows 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. For example, 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 they acquire a subtotal equal to at least 95% of their combined market price. As an example, using Option 3, an investor could identify ten replacement properties. If the total of their market value combined is equal to $10 million, they must ultimately purchase some combination of those properties with a purchase price of at least $9.5 million. Of course, the total also must be equal to or greater than the sale proceeds the investor seeks to protect from capital gains tax.
The second element of the timeline specifies that the investor must complete the replacement purchase within 180 days of the sale of the relinquished property. That includes the first 45 days provided to identify replacement properties.
Construction, improvement, and other special needs have supported the growth of reverse exchanges, in which the investor finds the replacement property before selling the asset targeted for relinquishing. The same timeline applies, but in reverse, and the Qualified Intermediary now serves as the exchange accommodation titleholder.
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 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. 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’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.