Introduction to 1031 Exchanges
What is a Tax-Deferred Like-Kind Exchange?
Many investors are avoiding selling rental or investment property these days due to the fact that they don’t want to pay income taxes; instead, they are trading these properties for larger rental or investment ones while deferring their capital gain and depreciation recapture income tax liabilities. This is an article that gives the Investor a general overview of that process.
Advantages of a Tax-Deferred Like-Kind Exchange
Typically known as a 1031 Exchange pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Department of the Treasury Regulations (“1031 Exchange”), federal, state, capital gain , and depreciation recapture income tax liabilities can often be avoided altogether by a tax-deferred like-kind exchange, which allows the Investor to sell rental or investment property and acquire more upscale rental or investment “like-kind” replacement property
Actual or Constructive Receipt
Receipt of 1031 Exchange funds occurs at the time the Investor has actual possession or control of said funds; the Investor is now allowed to have the funds during the 1031 Exchange period itself, or they may face a taxable event which may result in the complete disallowance of their 1031 Exchange transaction. The Investor must have the services of a Qualified Intermediary who will handle the purchase and sale agreements of the replacement property and the relinquished property and the replacement property before either transaction closes and/or are transferred to avoid this and to ensure that the transaction in question qualifies as a 1031 Exchange.
1031 Exchange Structures
A forward, or Delayed, 1031 Exchange is the most commonplace of all 1031 Exchange types; this is when the Investor acquires their like-kind replacement property either on the same day or at a later date after selling their qualified relinquished property first. The inverse is known as Reverse 1031 Exchange, which is when the Investor sells their relinquished property at a later date after acquiring their like-kind replacement property first.
The Qualified Intermediary (Accommodator or Facilitator)
The central factor in any 1031 Exchange is the Qualified Intermediary, also known as an Accommodator or Facilitator. The Investor chooses their own Qualified Intermediary, and they are in charge of writing up any and all 1031 Exchange agreements and filing/submitting any related documents in order to properly structure the Investor’s 1031 Exchange transaction. Your Qualified Intermediary will hold and safeguard your 1031 Exchange funds during your 1031 Exchange process, and they will handle each and every 1031 Exchange transaction; as a result of this, the Investor must carefully select their Qualified Intermediary, carefully evaluating their experience and expertise, errors or omissions on previous transactions, prior employee theft or embezzlement, and personal bankruptcy filings before engaging in business. This is something any professional will anticipate and understand due to the vast responsibility they shoulder during any transaction.
1031 Exchanges are beholden to very specific and unyielding time restrictions and cannot be altered under any circumstances, short of an Executive Order by the President of the United States. Among these restrictions are:
45 Calendar Day Identification Period
The Investor can choose possible like-kind replacement property(ies) to be acquired for only 45 calendar days from the close of their relinquished property sale transaction, including weekends and legal holidays. Properties can be changed at any time leading up to the end of the 45 day time period, but not after it expires.
180 Calendar Day Exchange Period
The Investor must acquire at least one of their chosen like-kind replacement property(ies) within 180 calendar days, including weekends and legal holidays, of the due date, including extensions, of their Federal income tax return for the year in which the relinquished property was sold, or by the close of their relinquished property sale transaction.
Full or Partial Tax Deferral
In order to defer 100% of the Investor’s Federal, state, capital gain and depreciation recapture income tax liabilities, the Investor must acquire like-kind replacement property that is equal to or greater in value than the relinquished property sold; reinvest all of the net proceeds or cash (net equity) generated from the sale of the relinquished property; and replace the amount of old debt that was paid off on the disposition of the relinquished property with new debt of an equal amount on the like-kind replacement property. The Investor can add additional funds into the 1031 Exchange transaction but they cannot remove any funds without recognizing depreciation recapture and/or capital gain income taxes; the only way to do so is to refinance the property before the 1031 Exchange transaction starts or after it has completed. 1031 Exchanges can also be utilized to defer only a portion of the Investor’s depreciation recapture and/or capital gain income tax liability, and to create partial recognition of the Investor’s depreciation recapture and/or capital gain income tax liabilities by trading down in value.
Qualified Use Property
The Investor must have the intent to hold their like-kind replacement property for rental, investment or use in his business, and have held their relinquished property for rental, investment or use in their business; otherwise, the property is not considered qualified for a 1031 Exchange, denying the Investor the benefits of tax-deferred exchange treatment.
Like Kind Property
In order to qualify for tax-deferred exchange treatment, relinquished and replacement properties must be like-kind, which means that all of the properties must be held for investment. Also, 1031 Exchanges can be used for personal property as long as the Investor is exchanging for like-kind personal property as well; personal property cannot be exchanged for real property, and vice-versa.
The same Taxpaying Entity/Investor who sold the relinquished property must be the same Taxpaying Entity/Investor who acquires the like-kind replacement property.
Multiple Properties and Fractional Interests
A 1031 Exchange is not limited to a single transaction; they can be sued for sale and acquisition of multiple relinquished and like-kind replacement properties.
1031 Exchange Requirement
A 1031 Exchange must be presented and structured as such from the beginning; if simply presented as a common deal for the selling and subsequent buying of properties it will not quality as a 1031 Exchange. Thus, the services of a Qualified Intermediary are needed.
Possible like-kind replacement properties must be presented by the Investor; however, these choices are not legally-binding and are done merely to satisfy this required step in the 1031 Exchange process. The potential properties can be changed at any time by the Investor until the end of the process.
And finally, the three following rules must be followed at all time in order to qualify for the benefits of a 1031 Exchange:
- The 95% Exception Rule:
95% of the fair market value of identified replacement properties will still be considered valid for a 1031 Exchange if Investor has to identify like-kind replacement properties that exceed the 200% of FMV rule and the three property rule.
- The Three (3) Property Rule: The most common of the like-kind replacement property identification rules, the Investor may select and present a maximum of three possible like-kind replacement properties, which allows the Investor to identify more than one property in case the initial property choice cannot be acquired; if this number of three properties must be exceeded, refer to the 200% of FMV rule below.
- The 200% of Fair Market Value Rule:
The Investor is allowed to identify more than three possible like-kind replacement properties provided their total fair market value does not exceed 200% of the sales price of the relinquished property(ies).
Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.
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