A 1031 exchange is a commonly used tax-deferral strategy that allows real estate investors to defer capital gains taxes by reinvesting in other qualifying investment properties. However, this process may be complex, and you may feel overwhelmed by the various rules set by the IRS. By focusing on the core provisions—such as property identification timelines, use of a qualified intermediary, and intent to hold for investment—you can better navigate a traditional exchange structure. Realized 1031 has shared a blog post diving back into these basics. Keep reading to learn more.
Understanding the Traditional 1031 Exchange
Named after Section 1031, the 1031 or like-kind exchange is a type of transaction where an investor swaps a real estate asset for another without immediately recognizing capital gains. Done successfully, this strategy allows you to defer capital gains taxes from the sale of the relinquished property, helping investors preserve capital and maintain tax deferral through continued investment in real estate.
Given the tax benefits of 1031 exchanges, they are subject to strict regulation by the IRS. To maintain your tax-deferred status, there are a few fundamental and inviolable rules to keep in mind.
- Real property: You cannot exchange other types of assets, like stocks or bonds. Only real property is allowed.
- Like-kind property: The properties must be of a similar type or nature. In the context of 1031 exchanges, this means that both relinquished and replacement properties must be held for investment or business purposes. As such, primary residences are not allowed.
- 180-day timeline: The entire transaction must happen within a 180-day timeline, which begins after the closing date of the relinquished property sale.
- Use of a Qualified Intermediary: To avoid constructive receipt of the proceeds, a qualified intermediary must hold the funds between the sale of the relinquished property and the purchase of the replacement property. Direct control or access to the proceeds may invalidate the exchange and result in immediate tax liability.
The above list includes some of the most critical 1031 exchange requirements, but it is not exhaustive. Section 1031 transactions involve numerous technical rules, and mistakes can result in loss of tax-deferral benefits, penalties, and capital gains tax exposure. Always consult a qualified tax advisor or legal professional to evaluate your specific situation.
Like-Kind Properties — What Counts?
What is considered like-kind according to the IRS? As we mentioned, so long as these properties are held for investment or business use, then they can be treated as similar in type or nature. Their current value or condition doesn’t matter. As such, you can exchange a multi-family home or an apartment complex, or farmland for a commercial building. What matters is the intent behind holding both the relinquished and replacement assets.
What doesn’t count as a like-kind asset? Any type of asset that isn’t real property is not allowed. Certain structured investments, such as beneficial interests in a Delaware Statutory Trust (DST), are treated as real property and may be used in a 1031 exchange. Primary residences are also ineligible because these properties are held for personal use. Secondary homes and vacation properties are allowed if they follow the rules set by Revenue Procedure 2008-16 , including adequate rental use and limited personal use over two consecutive 12-month periods.
Working With a Qualified Intermediary
Once you’ve chosen a replacement property that qualifies for the exchange, you’ll need to work with a qualified intermediary also known as an accommodator for the transaction. This third-party entity plays a key role in holding proceeds from the sale of your relinquished property and structuring the transaction to meet IRS requirements, particularly those related to constructive receipt and the timing rules. The accommodator will have a few tasks, such as the following.
- Hold the proceeds of the property sale in escrow or a separate account.
- Ensure that the persons named as owners of the relinquished property will be the same as the persons who acquire the new property (same taxpayer requirement).
- Structuring the transaction to comply with IRS safe harbor provisions and prevent disqualification due to improper handling of proceeds or title.
Given the responsibilities of the qualified intermediary, the IRS has also set strict rules regarding who can work as an accommodator for an investor. In general, anyone who is a blood relative, employee, or financial partner is not allowed to serve as your accommodator.
Identifying the Replacement Property
Within the 180-day timeline of the 1031 exchange, the first 45 days from the date of the sale to identifying the replacement property. In the context of like-kind swaps, “identification” refers to the crucial step of formally specifying the potential acquisitions that you intend to acquire using the proceeds from the sale of the relinquished property.
The identification process should include a clear description of the property — typically the legal address or other information sufficient to distinguish it from other properties. Then, you’ll need to submit the document to the qualified intermediary for evaluation.
To maintain compliance, the IRS permits three identification methods:
- Three-property rule: Identify up to three properties, regardless of their total value.
- 200% rule: Identify an unlimited number of properties, provided that their total fair market value doesn’t exceed 200% of the proceeds from the relinquished property.
- 95% rule: If you identify more properties than allowed under the 200% rule, you must acquire at least 95% of the total fair market value of all the identified properties. Failure to meet this threshold disqualifies the entire exchange.
Acquiring the Replacement Property
Once you’ve identified replacement properties, you have the rest of the 180 days to purchase one or more of them. This step will include negotiations, inspections, and the closing itself. As such, it’s important for investors to stay on top of the process to ensure they can finish the exchange within the timeline.
At closing, the qualified intermediary (QI) uses the exchange proceeds to acquire the replacement property on your behalf, ensuring that you never take possession of the funds. This marks the end of the exchange, assuming all other conditions have been met within the 180-day timeline. Many tax professionals recommend holding it for at least one to two years to support the investment-use requirement. Selling or refinancing immediately might raise a red flag, leading to IRS scrutiny.
Final Thoughts on Section 1031 Exchange Basics
The like-kind exchange may be complex, but understanding the core principles and rules provides a solid foundation that helps you navigate the process. By adhering to the timelines, the like-kind requirement, and the crucial role of a qualified intermediary, you can strategically defer capital gains taxes.
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.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.irs.gov/pub/irs-news/fs-08-18.pdf
https://www.investopedia.com/terms/l/like-kindproperty.asp
