The 1031 Exchange Purchase Process: Steps, Rules, and Strategies

There are numerous steps and legal considerations connected with completing a 1031 exchange transaction. Everything must be in order, from identifying the right replacement properties to closing within the IRS’ specific timelines. Failure to follow the rules means you forfeit potential exchange benefits like capital gains tax deferral. 

The Basics: 1031 Exchange Rules

For the most part, 1031 exchange rules dictate eligible replacement properties, timelines, and transaction intent and include the following mandates. 

“Like-Kind” Properties

According to the IRS, a property is considered “like-kind” if it is similar in nature to the one it replaces in the exchange. This definition can create confusion, as it implies that you might be required to swap a duplex for a duplex or a retail property for a replacement retail property. 

However, like-kind, in this case, refers to the property’s function, meaning real estate used for investment or business purposes. If your relinquished property is a condo unit, a like-kind replacement property might be another condo unit or rental property. 

Timelines

There are two important deadlines for a successful 1031 exchange:

• You must identify a suitable replacement property 45 days after selling your relinquished property.
• You must close on that replacement property 180 days after selling your relinquished property. However, if your tax return due date (without extensions) falls before the 180-day deadline, the exchange must be completed by that earlier date.

The above refers to calendar days rather than business days. It doesn’t matter if the deadlines fall on weekends or during holidays. At the same time, the timelines are concurrent. After the 45-day identification period, you have 135 days to close on the replacement property.

Steps to a 1031 Exchange Purchase

It’s important to focus on the following for a like-kind exchange property.

1. Hire a Qualified Intermediary

You’re not allowed to handle the proceeds of your relinquished property’s sale. This is the job of a Qualified Intermediary (QI). The QI is responsible for holding and reinvesting the sale into your relinquished property. Without the QI on board, the IRS can disqualify your exchange.

2. Identify the replacement property/properties

Once you’ve sold the relinquished property, the clock starts ticking, with the 45-day identification period deadline looming. During this period, you must find and identify replacement properties under the following:

• Three-property rule: You identify up to three potential properties of any value and acquire at least one
• 200% rule: You identify multiple properties as long as the total value doesn’t exceed 200% of your relinquished property sale price
• 95% rule: You identify more than three potential properties with a total value exceeding 200% of the relinquished property’s value, but you must acquire at least 95% of the total identified value to remain compliant

Once you’ve identified the potential replacement property or properties, you must provide a written list and submit it to your QI.

3. Close on the replacement property

Once you have identified your replacement property and entered into a purchase agreement, you have 135 days remaining (out of the total 180-day exchange window) to complete due diligence, schedule inspections, record necessary deeds, and secure insurance.

On closing day, your QI will transfer the exchange funds directly to the seller of the replacement property. The property is then deeded to you.

4. Report the exchange to the IRS

You must report the transaction in the tax year when your relinquished property was sold, even if you didn’t complete the exchange within that same year. Your reporting mechanism is Form 8824. 

5. Additional considerations

Even when your exchange is completed, there are other strategies to follow to help defer capital gains taxes and depreciation recapture:

• Extended holding period: Regarding 1031 exchanges, the longer you own the replacement property, the better you prove its intent as an investment. While there isn’t a specified ownership period, the general rule of thumb is a two-year hold to indicate investment intent.
• Property use: Again, under the category of “intent,” you can’t use that property for personal use. Except under specific IRS rules for vacation homes, which permit limited personal use (e.g., 14 days per year or 10% of rental days).

Know Before You Buy

Like-kind exchanges are complex, requiring adherence to specific steps and processes. This is true regarding identifying and closing on a replacement property. The correct procedure can help support a tax-advantaged strategy to help potentially grow your wealth or expand your portfolio.

Finding knowledgeable professionals who can guide you through the buying process is highly advisable. Before starting a 1031 exchange, contact the professionals at 1031 Realized. With decades of experience, these knowledgeable individuals can help guide you through the complexities of a like-kind exchange purchase.

For more information or to set up a no-obligation consultation, visit the website at realized1031.com.

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.