1031 Exchange Rules
Through a properly structured 1031 exchange, an investor sells a property, reinvests the proceeds in a new property, and defers any capital gain taxes.
How does it work? Well, IRC §1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
To understand the powerful protection that an exchange offers, consider the following:
This chart is for illustrative purposes only and does not guarantee returns
- An investor has a $500,000 capital gain and incurs a tax liability of approximately $125,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold.
- If the investor obtains a cash on cash return of 5% with an exchange, reinvesting $500,000 could yield $6,500 more each year than investing the after tax $375,000.
- The chart to the left shows the differences in investment return. Foreground is return on $375K invested at 5% and background is return on $500K which would be available with an exchange. Difference at only 7 years is more than $43,750K.
As the above example and chart demonstrate, properly completed exchanges can defer an investor’s capital gain taxes. They provide the potential for portfolio growth through increased returns on investment, by having the dollars not paid to Uncle Sam work for the investor.
With a few notable exceptions, the title to the Replacement Property must be held in the same manner as the title was held to the Relinquished Property.
Individual relinquishes——–Individual acquires
ABC Partnership relinquishes ——ABC Partnership acquires
XYZ Corporation relinquishes ——XYZ Corporation acquires
The basic exception is when you have disregarded entities for tax purposes. The new entity is disregarded for tax purposes when the exchanger uses the same tax identification number, as illustrated here and changes the title before or after the exchange:
Mary Jones……Mary Jones, LLC
ABC Partnership…..ABC, LLC
ABC Partnership…..MV-ABC, LLC
Another big tip is to understand the Three Property Rule: The Exchanger may identify up to three properties of any value.
Also, there’s the 200% Rule: The exchanger may identify more than three properties, but the total fair market value of what is identified cannot exceed 200% of the fair market value of the relinquished property. This is usually used in the following two situations:
a. Seller is selling unencumbered land and buying replacement land for cash.
b. Seller is selling a property leveraged at 65% or more and planning to acquire replacement property with similar leverage.
You may also benefit from the 95% Exception – If the Exchanger identifies properties in excess of both Rule 1 and Rule 2, then the Exchanger must acquire 95% of the equity of all properties identified.
Implementation of this third rule is useful when acquiring multiple houses/lots in a subdivision or when selling a greater priced property ($700,000) and acquiring during your 45 day identification period a series of inexpensive properties ($30,000 – $50,000) such as rental homes.
Delayed Exchange Time Limits
It’s also important to understand the reality around date of transfer. The "date of transfer" will be the date of recording or transfer of the benefits of ownership, whichever occurs first. If a party is executing a multi-property exchange with the purpose of bundling multiple properties to buy one larger property, the time limits begin to run on the date the Exchanger transfers the first relinquished property to the buyer.
The Exchanger will have separate identification periods for each property relinquished – the thing to watch out for – is: settlement must take place to bundle all relinquished properties into one within the first released property’s 180 day Exchange Period.
These time limits are set in stone. After 9/11 was the only time that interested exchangers saw an exception. The Treasury, acting on its own, granted an extension period reflective of the inability to conduct normal everyday business. Subsequently, Treasury has granted similar extensions for hurricanes and other natural disasters, but other than that, a successful exchange must be done within the time constraints, with no other exceptions.
Like Kind Property
In a tax deferred exchange you can exchange real property for any other real property in the United States or its possessions, if the property is held for investment purposes (you cannot 1031 exchange real property determined to be "dealer" property). With Rev. Proc 2005-14 your primary residence (IRC Section 121) can have IRC Section 1031 applied to its sale.
Deferral Of The Entire Capital Gains Tax
To obtain a deferral, the Exchanger must:
- Purchase replacement property that is equal to or greater in value than the relinquished property.
- Invest all of the net proceeds from the relinquished property.
- Obtain equal or greater financing on the replacement property than was paid off on the relinquished property. Exception: replacement property debt can always be offset with cash added to the exchange.
- Receive only like-kind property.
Working With a Qualified Intermediary (QI)
The Qualified Intermediary industry is not regulated. Anyone can call himself or herself a QI. The Final Treasury Regulations of 1991 streamlined the exchange process and defined the role of the Qualified Intermediary.
A Qualified Intermediary:
- Confers with you and your support staff so that 1031 rules and regulations are thoroughly understood.
- Prepares the necessary documentation and oversees each closing to assist in maintaining proper 1031 procedures.
- Provides guidelines and knowledge, and vigilantly observes the critical time limits throughout the entire exchange process.
A seller should contract with a QI/Company that is bonded and whose sole business is exchanges.
- Exchange Contract Cooperation Clause
The exchanger should have an exchange cooperation clause in the purchase and sale agreement for both the relinquished and replacement properties.
- Relinquished Property
Buyer hereby acknowledges that Seller intends to complete a tax deferred exchange under IRC Section 1031, provided that the exchange will not delay the closing hereunder or cause additional expense to the Buyer. The Seller’s rights under the purchase and sale agreement may be assigned to a Qualified Intermediary selected by the Seller for the purpose of completing the exchange. Buyer agrees to cooperate with Seller and the Qualified Intermediary selected by Seller (in the manner described in this paragraph) to complete the exchange.
- Replacement Property
Seller is aware that Buyer intends to perform an IRC 1031 tax deferred exchange. Buyer requests Seller’s cooperation in such an exchange and agrees to hold Seller harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Seller agrees to the assignment of this contract by the Buyer.