1031 Exchange

A Section 1031 exchange is a method available to property owners to delay or potentially eliminate taxes payable on the sale of property that is held for use in productive trade or business or held for investment.

The main principle behind this is that by deferring the tax, the property owner has more money available to invest in a replacement property. In short, the property owner can receive an interest free loan from the federal government (and in some states even the state government), in the amount of the taxes that would have had to be paid.

Completing a 1031 tax deferred exchange can sometimes be overwhelming if it is the first time. As such, it is crucial for the investor to understand the mechanics and rules associated with a 1031 exchange not only because it can minimizing your exposure, but also because of the ability to better strategize for optimal results. Below are questions and answers to hopefully provide you with the necessary information in successfully navigating through your exchange.

The two most common types of 1031 exchanges? 

The Delayed 1031 Exchange Rule : The Delayed, or Starker exchange is the most common type of exchange today. In this type of exchange, the relinquished property is initially sold at (Down Leg), and after a delay a replacement property is purchased (Up Leg). As with all other exchange methods, there are time constraints and rules that must be followed for the exchange to qualify.

Reverse 1031 Exchange Rule : The revers exchange is an 1031 exchange whereby the replacement property is purchased prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, (Refer to code Rev. Proc. 2000-37, effective September 15, 2000). Contact NNN360 for more information on Reverse Exchanges.

Requirements for a lawful exchange?

  1. What are not qualifying Properties – There are certain types of real estate that are specifically excluded from the section 1031 tax deferred exchange treatment. These include 1) property held primarily for sale (traders or packagers who buy for quick resale); and 2) interests in a partnerships.
  2. Proper Purpose – Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer’s personal residence will not qualify.
  3. Like Kind – Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
  4. Tax Deferred Exchange Requirement – The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031.

What are the general guidelines to follow in order to completely defer all the taxable gain?

  • The value of the replacement property has to be equal to or greater than the value of the relinquished property.
  • The equity in the replacement property has to be equal to or greater than the equity in the relinquished property.
  • All of the net proceeds from the sale of the relinquished property has to be used to acquire the replacement property.

What are the time restrictions on completing a Section 1031 exchange real estate transaction?

  • A taxpayer has forty five (45) days after the date that the relinquished property is transferred to properly identify potential replacement properties.
  • The exchange must typically be completed by the date that is 180 days after the transfer of the relinquished property.

How many properties can be identified in a 1031 exchange real estate transaction?  

The taxpayer must meet the requirements of at least one of these 3 1031 exchange rules:

  • 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
  • 200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
  • 95% Rule: The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.