A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred.
The term—which gets its name from Section 1031 of the Internal Revenue Code (IRC).
An exchange can only be made with like-kind properties. Internal Revenue Service (IRS) rules limit its use with vacation properties.
There are also tax implications and time frames that may be problematic.
What Is a 1031 Exchange?
The Exchange Process-4 Simple Guidelines
Qualifications
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The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred.
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The 1031 provision is for investment and business property, though the rules can apply to a former principal residence under certain conditions. There are also ways you can use 1031 for swapping vacation homes
Timeline
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If used correctly, there is no limit on how frequently you can do 1031 exchanges.
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within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property that you want to acquire.
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You must close on the new property within 180 days of the sale of the old property.
Rules
Identification of all potential replacement properties must be in writing and based on two rules provided by IRS:
1. The 3 property rule allows for identification of any three properties of any price, anywhere in the US.
2. The 200% rule, 4 or more properties can be identified. However, the combined value of all properties identified can't exceed 200% of the property sold.
3. All the cash generated from the sales of the old property must reinvest on the replacement property.
4. The value of the new property must be equal or greater than the property you relinquish.
Types of Exchanges
Simultaneous Exchange:
The old property is sold and the replacement property is acquired on the same day.
Delayed Exchange:
The most common situation, which allows investors to sell the property and acquire the replacement property within 180 days.
Reverse Exchange:
This allows investors to acquire replacement property prior to selling. It's complicated since the investor can't own both new and old properties at the same time.
Construction/Improvement Exchange:
This allows investors to use exchange proceeds to build on land or improve an existing property. please contact us to learn more details.
Frequently Asked Questions
Q: How long do I have to own a property before I can exchange it?
A: The longer the better. There is no required holding period. The property only needs to be “held for investment” to be eligible for trading. Time of ownership is only one factor that IRS uses fo determining the qualification of a property. Some tax advisors recommend a minimum holding period of one year.
Q: Can I sell my duplex and purchase raw land?
A: “To qualify, most exchanges must merely be of like-kind. " You can exchange an apartment building for raw land or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another but there are certain rules you need to be careful.
Q: Can I buy my replacement property first?
A: Yes. Reverse exchange applied.
Q: Can I move into a rental property that was originally purchased as part of a 1031 Exchange?
A: Yes. However, please keep in mind that the IRS will look at your “purpose of owning a property" to determine if your exchange is valid. If they think the property is acquired as primary residence, you may have your exchange disqualified. We recommend renting a property out for at least 2 years before self-occupancy.
Q: Do I have to reinvest ALL of my cash (equity)?
A: You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash, known as "boot" will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain. If you don’t want to pay any taxes, it'd better reinvest all the cash and purchase a property equal or greater in value.
Q: How long do I have to complete my exchange?
A: 180 days. However, also keep in mind you will be required to identify your potential replacement properties on day 45 of your exchange. Your timeline starts when you close escrow on the property you are selling.
Q: How do I start my 1031 exchange?
A: The 1031 Exchange account MUST be opened before close of escrow on the property being sold. At the close of escrow, Asset Exchange Company (AEC) will coordinate with the escrow company to obtain all of the necessary signatures on all exchange documentation.Depending on the nature of the transaction, additional steps may need to take place. Asset Exchange Company will work closely with the client to ensure a successful transaction.
The content provided is a courtesy of The Official 1031 Exchange Guidebook from Asset Exchange Company and is meant for general information purposes only. It does not, and is not intended to, constitute tax and legal advice. Investors should consult accountants or lawyers to ensure proper compliance with laws.