– A Plain English Guide for the Modern Real Estate Investor –
This post covers the basic 1031 exchange rules and regulations set forth by the IRS, the IRC, and various tax courts. If you have questions about terminology or can’t find an answer below, CONTACT OUR STAFF DIRECTLY, or try one of the resources below:
Eligible properties for a 1031x
Both the relinquished property and the replacement property must be held for a “qualified purpose.” In other words, any 1031 property must be (A) used for investment or (B) used in trade or business. If you hear industry lingo about “like-kind” properties, this is what it means.
You can, for example, sell a ranch and 1031x into a mobile home park. Or, you can sell a conservation easement and buy an oil well. Such broad classifications mean that you can change the nature of your real estate investment and still qualify for tax deferral. This makes 1031 exchanges a very powerful investment tool.
It is OK to exchange multiple relinquished properties for one replacement property or vice versa. An Exchanger may also sell 100% of the relinquished property and buy only 5% (for instance) of the replacement property.
This rule creates interesting possibilities with regard to selling 100% of a small property and buying a larger property with other like-minded investors as tenants in common.
Gray areas: vacation homes and homes occupied by relatives. Note that dual-use properties — that is, properties which you occupy as your principal residence and also hold for investment — usually qualify for 1031 exchange treatment on the portion held for investment.
All of the following 1031 exchanges have been approved (though various tax rulings):
- Improved property for unimproved property.
- Commercial building for vacant lots.
- Urban property for a farm or ranch.
- Real property for real property that includes a personal residence.
- 100% of one property for a smaller fractional interest in another property (or vice versa).
- Multiply parcels of real property for a single parcel (or vice versa)
- Real property for water rights.
- Real property for oil and gas interests (as long as the O&G interest is perpetual).
- Real property for transferable development rights.
- Real property for an easement.
- Real property for a coop.
- Real estate for a life estate.
- An option to buy real property for real property.
- Real property for a contract for deed.
- A conservation easement for real property.
- Termination of a tobacco quota for real property.
- Real property for a beneficial interest in a Delaware Statutory Trust (DST).
- Real property for an LLC ownership interest that results in you owning 100% of the LLC.
In general, the IRS defers to State law for definitions of “real property.” If your State defines, or taxes your asset, as real property, then the IRS will also recognize it as real property for purposes of 1031 exchange.
Eligible locations for a 1031x
Of course, you may also exchange real property in one state to real property in another state. Be warned, some states do not recognize 1031 exchange with regard to state income taxes (e.g. Pennsylvania), while other states will impose a tax if an out of state 1031 replacement property is ultimately sold in a taxable transfer (e.g. California).
You may NOT exchange foreign real property into a domestic property (or vice versa).
Why Qualified Intermediaries play an Important Role
You need a neutral, third-party qualified intermediary (“QI” or “accommodator”) to help you perform a successful 1031 exchange. Why? Because the IRS says so. [See Treasury Regulation §1031.1031(k)-1(g)(4)(iii)]
It is the QI’s job to help you explain, coordinate, and execute the 1031 process. You’ll sign an agreement with your QI that limits your rights to “receive, pledge, borrow, or otherwise obtain benefits of money or other property” held during the 1031 exchange.
Just as critically, your QI should help you set up a secure escrow account. This is where your exchange proceeds will stay after you sell the relinquished property. When you are ready to close on your replacement, the QI ensures that the proceeds arrive safely and on time.
1031x.com, Inc. has been a trusted qualified intermediary for more than 25 years. We provide all services in accordance with the Internal Revenue Code and the Treasury Regulations. Our company is a proud member of the Federation of Exchange Accommodators (FEA).
Follow these rules and you will avoid paying any capital gains or depreciation recapture taxes on the sale of your investment real estate.
- Identify what you want to buy within 45 days after the sale. The IRS limits 1031 exchanges, in part, by forcing you to identify your replacement assets within 45 calendar days of the transfer of your relinquished property. It also limits how much you can identify three potential purchases. (Technically, you can identify more than three, but the rules become challenging. Ask a coordinator about this option.)
- Buy what you want within 180 days after the sale. Another limitation, although usually less restrictive than the 45-day rule. You get six months to execute your exchange. Any proceeds not reinvested after the 180th calendar day become taxable. It’s important to remember that you must close and take title within 180 days; it is not enough to go under contract.
- Trade equal or up in net sales price. The replacement property must be of equal or greater value than the relinquished property, but after factoring in closing costs. For example, take a $500K rental with $20K in closing costs. To fully defer taxes, you must purchase at least $480K in replacement assets. If you trade down in value, then you pay tax on the difference.
- Reinvest all of the proceeds from your sale. All of the cash proceeds from the sale of the relinquished property must go toward the replacement property purchase. Remember that all proceeds must flow through your 1031x escrow account.
- Don’t take out any money. If you receive any proceeds directly, they immediately become taxable (limited by the total amount of gain in the transaction). Only the proceeds you take out are taxable; any funds correctly escrowed with your QI can be exchanged without tax.
- Keep your property title consistent. Whichever taxpayer that sells the relinquished property must also buy the replacement property. This may seem like an obvious rule. However, it sometimes creates great difficulty. If a multiple owner limited liability company or a corporation owns the relinquished property then that entity must also own the replacement property. The owners of the company cannot own the replacement property in their individual names. What if some owners want to do a 1031 exchange and some do not? Or if the lender requires that an individual own the replacement property?
What happens to tax basis in a 1031 exchange?
The basis of the relinquished property will carry forward into the replacement property.
TIP: The easiest way to calculate the basis in the replacement property is to start with its purchase price, then reduce this number by the amount of gain deferred in the 1031 exchange.
We’ve only covered the very basic 1031 exchange rules here. Each exchanger’s circumstances are different; your circumstances may not qualify for tax deferral or may require additional strategies.