A successful 1031 exchange can be a powerful tool to help you defer capital gains and depreciation recapture taxes from the sale of property used for investment or business purposes. However, there are limitations to the process.
The IRS imposes rules and regulations for using the like-kind exchange. Understanding these restrictions helps determine if using a 1031 exchange to achieve real estate investment goals works for you.
Limitation 1—Like-Kind Property Requirements
The replacement property you buy must be “like-kind” to the relinquished property you sell. This doesn’t mean they have to be the same type of real estate. A like-kind replacement property:
- Is held for investment or business purposes
- Is of greater or equal value to the relinquished property to fully defer taxes (though partial exchanges are possible with taxable boot).
- Qualifies as real estate (not securities, certificates, partnership interests)
- Is not used for a primary residence
- Is not foreign property (if U.S. property is involved)
Limitation 2—Rigid Timelines
In addition to like-kind property rules, the IRS has mandated timelines that must be followed to ensure a 1031 exchange is completed successfully. Specifically:
- You have 45 days from the date you sell your relinquished property to identify a replacement property
- You have 180 days from the date you sell your relinquished property to buy that replacement property
Furthermore, these deadlines are “calendar” dates. It doesn’t matter if they fall on a weekend or a holiday. They must still be observed.
Limitation 3—Replacement Property Identification
You must provide an in-depth, in-writing description of the replacement property. Furthermore, you must follow one of three rules for identifying the properties:
- Three-property rule: Identify up to three potential replacement properties, regardless of value, and acquire at least one of those assets by the 180-day deadline.
- 200% rule: Identify any number of replacement properties as long as the fair market value of those combined properties doesn’t exceed 200% of the value of your relinquished property.
- 90% rule: Identify any number of replacement properties as long as you acquire at least 90% of the total fair market value of the identified properties.
Limitation 4—Qualified Intermediary Obligations
As an investor involved with a 1031 exchange, you’re not allowed to take control of proceeds when you sell your relinquished property. In fact, the IRS requires using a Qualified Intermediary (QI) as part of the exchange. This entity takes control of the relinquished property’s proceeds and uses them to close on the replacement property. The QI also handles documentation and paperwork. Failure to retain a QI voids the exchange and triggers a taxable event.
Learning About Limitations
A 1031 exchange can provide substantial tax benefits. At the same time, it involves several limitations you need to understand and navigate. Strict timelines, identification rules, and property requirements can complicate the exchange process.
Before starting a like-kind exchange, take time to understand the potential challenges involved. Ask your tax professional or attorney about the pros and cons of the process and the steps for moving it forward. Then, determine if becoming involved with a 1031 exchange works with your financial and investment strategies.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
