Insightful real estate investors use tax-deferred exchanges to help build wealth through the deferral of capital gains taxes. To take advantage of this tax law, investors must use the proceeds of property sales to purchase a replacement property.
Learn what properties qualify for this exchange and the criteria to follow to ensure the IRS approves your replacement property.
What Is a Replacement Property?
Replacement property is the property an owner acquires or buys during a capital gain tax-deferred exchange. This includes a 1031 exchange, where real estate investors can use the proceeds of a sale to purchase like-kind property for investment or business purposes of equal or higher value.
If a real estate investor sells a property they originally purchased at $250,000 for $750,000, they will earn a profit of $500,000. To avoid paying capital gains taxes on this amount, an investor can use the funds to buy a like-kind property valued at $500,000 or more.
The replacement property can be in a separate location, for example, selling a property in Massachusetts and buying property in Louisiana. It can also be a different type of property, exchanging a retail property for a residential rental.
Equity ownership of large properties by multiple investors also qualifies as replacement property. If you have a profit of $300,000, you can decide to place $200,000 in a Delaware Statutory Trust (DST) that owns a commercial building in California and $100,000 in a tenancy-in-common (TIC) property in New Jersey.
IRS Criteria for Replacement Property
To qualify for a 1031 exchange, your replacement property must meet specific IRS regulations. If you don’t follow the guidelines precisely, the IRS can hold you liable for taxes, interest, or penalties. Your 1031 exchange needs to be reported to the IRS through Form 8824 and filed with the tax return for the year the exchange happened.
Replacement Property Must Be Like-Kind
The IRS considers property used for business, investment, or trade to be like-kind. Properties used for personal use, including a second home or vacation home, do not qualify for replacement property.
They must also be of the same character, nature, or class, but overall quality does not matter. Most types of real estate are considered like-kind to other real estate, as long as it is located in the United States.
The IRS does not consider property outside the US to be like-kind for a replacement property in the US. One exception is that properties without land are not considered like-kind for land.
You Are Required to Meet Two Time Limits
You have 45 days from the sale of your original property to identify possible replacement properties in writing, including a description of the property and its address. You must sign the document and send it to the seller of the replacement property or your exchange intermediary within this time frame.
You have 180 days to complete the exchange for your replacement property, from the sale date of your property to the time the exchange is completed.
Avoid Premature Receipt of Proceeds
Taking control of your proceeds or cash before the exchange is finalized can disqualify it, leaving you vulnerable to immediate capital gains taxes. You may also face taxes if you receive proceeds or cash that are not considered like-kind property as the exchange is concluding.
In this situation, your like-kind property still qualifies for tax deferment, but the gains from the cash and other proceeds can be taxed. To keep this from occurring, use an intermediary who can retain the proceeds of the exchange until it is finalized.
A Qualified Intermediary Is Necessary
You are not allowed to act as your own facilitator of your exchange. You cannot use a real estate agent, broker, attorney, accountant, or anyone you have worked with in a real estate capacity as an intermediary. A qualified intermediary will be experienced in 1031 exchanges and can guide you through the process to ensure you meet all deadlines and requirements.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
