What is a 1031 Exchange?

A 1031 exchange allows an investor to sell one or more appreciated assets and defer the payment of capital gain taxes by acquiring one or more replacement properties. 1031 tax-deferred exchanges allow investors to keep 100 percent of their money instead of losing about one-third of their equity to taxes, and allows investors to purchase substantially more replacement property.

The 1031 “like-kind” exchange should be considered by every taxpayer who is planning to reinvest the proceeds from a sale of investment property into another similar type of investment property. The IRS Code Section 1031 describes the “like-kind” exchange: 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 of business or for investment.

What Qualifies as a Like-Kind Property?

“Like-kind” property can be any property used in a trade or business or as an investment. All of the following real estate can be exchanged as “like-kind” property:

What is a Qualified Intermediary?

The use of a Qualified Intermediary (QI) or Accommodator is mandatory for a successful 1031 exchange. An independent third-party is typically hired by the investor to receive the funds at the time of sale for the investor’s relinquished property. This third-party holds those funds until the investor is ready to acquire the replacement property. The primary role of the QI is to ensure that the investor does not receive any monetary benefit from the sale of the relinquished property which would trigger a taxable event.

1031 Exchange Timeline

Timelines are important in a 1031 exchange and missing specific deadlines could also trigger a taxable event for the investor. At its most basic, the investor must identify a replacement property within 45 days of the original property’s sale. Furthermore, the investor must then close on the sale of the replacement property within 180 days of the first sale.

1031 Exchange Identification Rules

In order to meet the first timeline requirement of identifying a replacement property within 45 days, investors can choose from several options:

Three Property Rule | One of the more common options, this rule allows investors to identify up to three replacement properties without taking into account the fair market value of those properties. This strategy is useful in case the first or second choice properties fall through, or if the investor is looking to acquire multiple properties in the “up leg” of his or her exchange.

The 200% Rule | This rule allows investors to identify an unlimited number of properties as long as the cumulative fair market value of those properties does not exceed 200 percent of the value of the relinquished property. This strategy is more often used in exchanges with larger dollar amounts, while we see the “three property” rule used more frequently in smaller exchange transactions.

The 95% Rule | While not commonly used, investors also have the option of identifying more than three replacement properties with unlimited value. However, the investor must acquire at least 95 percent of the fair market value of the properties he or she has identified, which can be challenging to achieve.

Specific Description of the Replacement Property

When identifying the replacement property or properties, investors must be specific in their description. Ambiguous language or descriptions that aren’t clear will not satisfy the guidelines of a 1031 exchange. Details such as the property address, a legal description of the asset’s location, or a distinguishable property name are acceptable and must be submitted to the QI no later than 45 days after the sale of the relinquished property.

A 1031 exchange can be an extremely valuable tool for investors when utilized properly. Again, all rules and guidelines must be followed explicitly, or investors risk triggering a tax event. Proper consultation with tax advisors and legal counsel who are experienced in 1031 exchanges is strongly recommended for investors looking to receive the greatest tax deferral benefits. Likewise, qualified real estate investment brokers can help investors navigate the 1031 exchange process and determine the right strategy for an individual’s exact needs.