What Happens When You Sell a 1031 Exchange Property?

Let’s take a hypothetical situation. 

You might own a rental property acquired through a 1031 exchange process. Now you’re ready to sell. Maybe you want a better-quality asset that might yield a higher cash flow. Or perhaps you wish to acquire fractional shares in a Delaware Statutory Trust for potential diversification benefits.  

You know you could sell your property as you acquired it – through a 1031 exchange. But what happens when you sell your 1031 exchange property? 

This is a valid question. You need to follow specific steps to sell your relinquished property and obtain its replacement. Failure to do so could result in a hefty bill at tax time. 

The Timing: When to Sell 

What can confuse the process is that the IRS doesn’t recommend a specific “sell-by” date concerning your like-kind exchange-acquired property. But exchanging your relinquished property for a replacement property too soon could raise some red flags. It brings up the question of “intent.” Specifically, did you acquire your property only to flip it? “Flipped” properties are not compatible with 1031 exchanges.  

The IRS is adamant that any exchange-eligible property must be “held for trade or investment.” Because of this, the general rule of thumb is to hold your property for at least one year after you buy it. This means that the property is recorded on consecutive tax filings. The longer you can hold that property, the better. 

The Deadlines: When to Identify and When to Close 

Another issue on which the IRS is immovable is like-kind exchange deadlines. Specifically: 

You have 45 days from closing your relinquished property to identify your replacement property or properties. It’s not enough to point and say, “That one.” You must provide specific written documentation to your Qualified Intermediary regarding the property’s legal description, street address, and other information. 

You have 180 days from closing your relinquished property to close on your replacement property or properties. Again, the clock starts when you sell your relinquished property, NOT when you identify your replacement property. Adding to this issue, you must close on your replacement property: 

• The earlier of 180 calendar days, or 
• The due date for filing your tax return for the year in which the property was sold 

Another important point? These are “calendar” deadlines. In other words, if the 45th day falls on a weekend, this doesn’t matter. You must identify that property. This also holds for the 180-day deadline. If the deadline falls on Christmas Day, you need to close on Christmas Day. Or ideally, before that holiday. 

The Replacement: How Many? 

Mention the word “like-kind exchange,” and what might come to mind is “one-to-one.” But under the Three Property Rule, you can identify up to three replacement properties for your relinquished one. But those properties must be of equal or greater value to your replacement property. You must acquire one of the three as the replacement property within the 180-day exchange period. 

Know the Process 

A clear understanding of the steps to take ensures a seamless 1031 exchange. This can help you defer capital gains and depreciation recapture taxes while potentially enhancing your investment strategy. 

The like-kind exchange process can be highly complex, requiring adherence to deadlines and other regulations. Because of this, always check with your qualified tax professional before embarking on the 1031 exchange.