Executing a 1031 exchange to defer capital gains taxes when buying and selling an investment property can be a helpful tool for taxpayers. If you sell investment real estate at a profit, you will owe capital gains taxes on any appreciation in the value. Paying those taxes can adversely impact your reinvestment by reducing the amount available. If you structure the sale and purchase using a 1031 exchange, you can defer the payment of the capital gains taxes.
In a 1031 exchange, investors can identify up to three potential replacement properties–contrary to the common assumption of a one-to-one exchange. It's crucial to meet IRS-defined deadlines, including a 45-day window post-sale of your initial asset for property identification. A clear understanding of these steps ensures a seamless 1031 exchange, helping to defer capital gains tax and potentially enhance your investment strategy.
Investors can choose to identify more than three potential replacement properties using the 200 percent or 95 percent rules. Keep in mind that the replacement property the investor acquires must at least equal the price of the relinquished property. You can definitely buy multiple properties in a 1031 exchange.
The 200 percent rule allows the investor to identify as many properties as they prefer, but the combined value of all identified assets can’t exceed 200 percent of the relinquished asset’s value. For example, if the relinquished property sells for $1 million, the potential replacements can equal a combined value of $2 million.
The 95 percent rule also allows the investor to identify an unlimited number of properties with no limit to the total value. However, the investor must purchase at least 95 percent of the value identified. If the investor identifies $2 million in value, no matter how many assets combine to reach that value, they must purchase 95 percent of the identified value, or $1.9 million.
In reference to a 1031 exchange, “identification” is a formal process. The investor notifies the Qualified Intermediary (QI) of the properties identified for consideration. The investor must do this within 45 days of the original sale. The Qualified Intermediary also maintains the proceeds from the original sale, ensuring that the investor does not have access to the funds. The QI keeps track of the necessary paperwork and oversees the purchase of replacement properties.
The Qualified Intermediary cannot be the taxpayer, anyone related to them (except by marriage), or an agent, employee, or business associate.
While the identification process allows the inclusion of multiple properties for potential acquisition in the 1031 exchange, the method used will determine the number that the investor ultimately buys.
Suppose the investor successfully completes a 1-31 exchange and later sells one or more of the replacement properties without executing an additional 1031 exchange. In that case, they will owe capital gains taxes on the sale, plus the taxes that they previously deferred. For example:
Joe sells Property A using a 1031 exchange to buy Property B and Property C. He defers the $30,000 in capital gains due for the sale of Property A. Several years later, if Joe sells Property B or C without completing another qualified exchange, he will owe the taxes due on that sale plus the original $30,000 that he previously deferred. However, if Joe uses the 1031 exchange to defer the taxes for each transaction, he can continue the deferral of accumulated taxes. When Joe finally distributes assets to his heirs, they will not pay the taxes because they receive the property at the current fair market value.