What is a 1031 Exchange?
A 1031 Exchange – named for section 1031 of the Internal Revenue Code – is a way for investors to defer capital gains tax when exchanging one investment for another of “like kind.” In the real estate world, that means that an investor can sell their investment property, use the funds for investment in other real property, and defer payment of any capital gains taxes that would otherwise be due.
The definition of like-kind within real estate is very broad. It is interpreted to allow exchanges of any type of real property for any other. The number of parcels is immaterial; for instance, one apartment complex can be exchanged for five single family dwellings. The qualification is that it must be investment property! An owner cannot use 1031 exchange to replace their principal residence.
It is imperative for a 1031 Exchange that the principal does not have access to the funds in between the sale of the first property and purchase of the replacement property. If the money reaches the principal at any point, they will lose the opportunity to defer their capital gains tax. For this reason, it is far better to over-communicate than under-communicate with escrow on the sale of the initial property that it is part of a 1031 exchange and the money is not to be wired to the seller.
Instead, the funds must be held by a Qualified Intermediary (QI). There are numerous companies offering this service. It is important to vet QI candidates carefully as they will be responsible for all the funds in between the sale of the first property and purchase of the replacement(s).
Timelines to identify and close
After the close of the sale of the first property, the principal has up to 45 days to identify potential replacement properties and up to 180 days to close escrow on the replacement(s). There are stringent and complex rules around the identification of properties – below is a rudimentary summary for informational purposes only. Note that this should not be used as a substitute for legal advice or the advice of a tax accountant!
What else do I need to know about 1031 Exchange?
If you are pondering a 1031 Exchange, consult with a tax, financial, or legal professional for details about what options are available and best for your particular situation. The information below is for general educational purposes and cannot be considered legal or tax advice.
What counts as identifying a property?
Replacement properties are identified:
- De facto by executing a contract to purchase the replacement property, or
- When specifically named in writing submitted to the QI
Are there limits on how many properties I can identify?
Yes. The most commonly known options are:
- Up to three properties can be identified, any or all of which can be purchased
- Any number of properties can be identified if the market value does not exceed double the value of the original property
- Any number of properties can be identified if the principal closes acquisition of 95% or more (by market value, not by units) of the identified properties
What happens if I miss the deadline to identify or close?
If you miss the deadline to identify or close, or do not properly identify the replacement properties, the ability to defer the capital gains tax on the transaction is lost.
Does the replacement property have to be the same value as the initial property?
To defer capital gains taxes, the replacement property can be the same value or more as the property sold. If it is purchased for less than the sale amount of the original property, the entire difference is subject to capital gains tax (the basis is considered $0 as the actual cost basis is rolled into the replacement property).
The exact same taxpayer, whether an individual, group of individuals, or entity, must be the seller of the initial property and buyer of the replacement property in order to use a 1031 Exchange.