Many factors can affect the validity of a §1031 Exchange, but the following are basic rules that apply to most §1031 Exchanges.
IRC §1031 allows a property owner to exchange one investment property for another investment property that is considered ‘like-kind’. With real estate, the owner can exchange an investment property – such as an apartment complex – for another investment property – such as another apartment building, or a shopping mall or vacant land. For example, properties exchanged may be any combination of:
With real estate, the owner can exchange an investment property – such as an apartment complex – for another investment property – such as another apartment building, or a shopping mall or vacant land.
Office, multi-use, or
Motels / Hotels
Single-family home rentals
Industrial / Warehouses
Farms / Ranches
Certain leasehold interests
However, real property cannot be exchanged for a different kind of investment such as an airplane. Also , an owner cannot include his/her personal residence in the §1031 Exchange.
In order to defer all capital gains tax, the new / Replacement Property should be of equal or greater value than the Relinquished Property (the original property being sold).
The person who sells the Relinquished Property must be the same person who acquires the Replacement Property. For the independent investor, this is a simple dictum. However, for a multimember LLC, this issue can become considerably more complex.
To make a valid exchange, the Exchanger must:
If the tax return is due before the 180-day period is over, the person doing the §1031 Exchange can extend the exchange period by filing for an extension of the tax due date.
The Exchanger must buy a Replacement Property of equal or greater value to the Relinquished Property in order to completely defer the applicable capital gains tax. If the Exchanger purchases a property of lesser value, he/she will be responsible for any tax on the difference. The Exchanger must also use all the cash proceeds from the sale on the purchase in order to completely defer the applicable capital gains tax. If the Exchanger does not use all proceeds on the purchase, he/she will be taxed on the difference.
The owner/seller should use all of the proceeds from the sale of the Relinquished Property to acquire the Replacement Property in the §1031 Exchange. The owner/seller is not entitled to use any of the proceeds from the sale or leave those proceeds in an account to which the owner/seller has even indirect access. IRS regulations require that proceeds of the sale be held by a “Qualified Intermediary.” At the time of the purchase of the Replacement Property, if the Exchanger wishes to take any part of the proceeds from the sale of the Relinquished Property, he may but has to pay capital gains taxes on that portion.
Generally the debt, or mortgage, on the Replacement Property should equal or exceed the debt on and the value of the Relinquished Property. However, the person doing the §1031 Exchange can opt to carry less debt on a Replacement Property if cash is added from other sources (e.g., personal savings.) However, the cash value cannot be replaced with debt because any proceeds that are received by the Exchanger is considered boot. All the cash must be used in the purchase and all the debt must be rolled over.
The Exchanger must submit a signed, written statement to an unrelated third party – such as the Qualified Intermediary – identifying potential replacement properties no later than 45 days after closing on the Relinquished Property. To qualify, the potential Replacement Property(ies) identified must satisfy one of the following rules:
THE THREE PROPERTY RULE: Identify three properties regardless of their market value.
THE 200% RULE: Identify any number of properties as long as their combined fair market value does not exceed 200% of the fair market value of all relinquished properties.
THE 95% RULE: Identify any number of properties, no matter what the aggregate fair market value, provided that 95% of the value of the identified properties are acquired.
The issue of constructive receipt is crucial to the success of the §1031 Exchange. If the person doing the §1031 Exchange is in constructive receipt of all or any portion of the proceeds from the sale of the Relinquished Property, those proceeds are taxable — defeating the whole purpose of the §1031 Exchange. For that reason, it is important for the Qualified Intermediary to take possession of exchange funds upon sale of the Relinquished Property, and hold those funds until the purchase of the Replacement Property. Any individual who is authorized to act on the investor’s behalf – such as the investor’s attorney, CPA, Realtor, Financial Advisor or anyone that has represented the Exchanger in the past two years — cannot serve as the Qualified Intermediary for the §1031 Exchange, according to the IRS. This violates the rule barring constructive receipt of funds.