1031 Exchange deferred tax
A 1031 tax-deferred exchange is a transaction that allows owners to preserve the full value of their investment property. A 1031 exchange allows owners who choose to dispose of their investment properties to do so and avoid having to pay capital gains taxes by allowing them to reinvest the proceeds of their sales in “like” properties.
The general rules governing a 1031 exchange are pretty simple. Any type of property (real or personal) can be exchanged as long as the transferred property has been previously held for investment purposes. In most circumstances, a personal residence will not qualify as a tax-deferred exchange.
- As kind The replacement property must be of a “like type” as the relinquished property. “Like kind” doesn’t exactly mean the same thing. Most real estate is considered “like” other real property, such as exchanging a single-family rental home for a condo, warehouse, or office building.
- PROPERTY VALUE As a general rule, the property you acquire should have a value and equity equal to or greater than the property relinquished.
- PERIOD IDENTIFICATION – The property to be acquired must be identified within 45 days after the closing of the transferred property. Property identification rules include:
- Three (3) PROPERTY RULE: Up to three (3) properties can be identified, regardless of their value,
- GOLD 200 PERCENT RULE: Any number of properties can be identified, as long as their combined fair market value is not more than double that of the relinquished property.
- GOLD 95 PERCENT RULE: Any number of properties can be identified, regardless of their combined fair market value, as long as you acquire 95% of that total value.
- CHANGE PERIOD – The acquisition of the new property must be completed within 180 days of the transfer of the relinquished property, or before the filing date of the tax return for the year the first property was transferred, whichever occurs first. These time restrictions must be strictly followed for the change to be allowed by the IRS. IRS do not grant extensions.
- STEPS INVOLVED IN A SUCCESSFUL EXCHANGE
- Purchase contract. A contract is executed between the Buyer and the Seller for the purchase and sale of the transferred property. The purchase contract must contain a “cooperation clause” in which the Buyer agrees to cooperate with the Seller to structure and complete a 1031 exchange. The Seller (or Buyer) will assign its interest in the agreement to a Qualified Facilitator or Intermediary ( FAC or QI).
- Open exchange. The exchange is established with the FAC or QI generally after the escrow has been opened to close the sale. Then the necessary documentation must be prepared to affect the exchange. The Exchange Contract (between the taxpayer and the FAC or QI) defines the exchange transaction and establishes the obligations of both the taxpayer and the FAC or QI. An Assignment of the contract for the sale of property assigned to FAC or QI is prepared, assigning the rights as Seller to FAC or QI.
- Close the ceded property. The transferred property closes when all conditions of sale are met and the property is transferred to the Buyer. While the transfer will be directly from the Seller to the Buyer, it will represent a transfer from the Seller to the FAC or QI in exchange for receiving other property at a later date. Proceeds from the sale are given directly to the FAC or QI for the replacement property. At no time should the Seller be in the actual or implied receipt of the cash proceeds.
- Replacement Property Identification. The time period to identify the property (or properties) to be purchased as replacement property begins with the closing of the relinquished property. Forty-five (45) days are allowed from the date of transfer to identify the acquisition property.
- Replacement Property Purchase Agreement. After identification of a suitable “like” replacement property and a decision on which property to acquire, a purchase contract will be signed with the Seller. The property must be one or more of the properties identified at the end of the 45-day identification period.
- Exchange documentation for the acquisition property.. Next, the Assignment of the purchase contract of the replacement property and the Release and Warranty must be prepared to be executed by the Buyer and the Seller. Instructions should also be prepared for the settlement agent to make a note of the items necessary to complete the exchange.
- Close the replacement property. When the closing conditions have been met, the FAC or QI must turn over the funds it has been holding to the settlement agent to acquire the replacement property. The Seller will transfer the replacement property directly to the Buyer. The closing of the replacement property must occur within 180 days of the transfer of the relinquished property (or before the tax return due date, if earlier) for the transaction to qualify for Section treatment. 1031.