The 1031 exchange is a beneficial tool for investors to use when considering changes to the investment portfolio. Perhaps you are seeking to diversify your asset mix or shift from direct ownership to fractional investments. You can work toward various goals without paying taxes on the appreciation of the properties you are selling if you work within the exchange rules.
What are the rules for a 1031 exchange?
- The relinquished (sold) property and the replacement (new) property must be "like-kind." This requirement has been interpreted to mean almost any kind of investment or business property. You may not exchange a primary residence for an investment property. In fact, a primary residence does not belong in a 1031 exchange unless some portion of it is also business property. You can exchange an office building for vacation rentals or retail property for multi-family housing.
- The investor/taxpayer must not control the proceeds from the relinquished property in the period between the sale and the time that the money is used to purchase the replacement property. A qualified intermediary must handle the funds, and that person may not be you or be related to you or employed by you.
- The investor must formally identify potential replacements (according to precise guidelines) within 45 days of the first property sale and then complete the transaction within 180 days, which is inclusive of the first 45 day period. This 180 day period is the maximum time that the funds can be retained in the escrow account that the qualified intermediary has established for the exchange. Suppose the transaction is not completed within this designated time. In that case, the deal will not be qualified, and the taxpayer will pay a capital gains tax on the appreciated value of the sale.
What are the risks of failure?
The common points of failure are in the timeline. Identifying the properties for replacement is guided by a strict 45-day timeline, which starts running when the relinquished property transaction closes. The investor has three options for identifying the replacements:
- Option 1 allows the investor to identify up to three properties as prospective purchases, with no restrictions on their individual or combined market price. Ultimately, if the individual buys a property or properties with a total cost (including costs associated with the transaction and any improvements) that is less than the value of the sold asset, they would have to recognize the capital gain on the difference.
- Option 2 allows consideration of any number of replacement properties, up to a total limit of 200% of the price of the property sold. If the relinquished property is worth $1 million, the seller can identify any number of replacement assets totaling up to $2 million.
- Option 3 allows the taxpayer to specify an unlimited number of properties but requires that they purchase some number of them with a value of at least 95% of their total market price.
These stipulations make the identification process a key element in the success of the exchange. Following the formal identification by the investor to the intermediary, the final selection and completion of the replacement property transaction or transactions needs to be finished by the end of the 180-day period, as specified.