The IRC Section 1031 Exchange is a powerful tax saving and wealth building tool that allows a taxpayer to sell property and purchase other property without currently recognizing capital gain tax on the sale. To quote the tax code: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment purposes if such property is exchanged solely for property of a like-kind which is to be held for either productive use in trade or business or for investment purposes”.
How does a 1031 exchange work?
- First the property seller must identify in writing their intent to do a 1031 exchange prior to the closing on the relinquished property. At the closing of the first property the seller includes the exchange language in the buy-sell agreement. This is very important because if you have already sold the property and received any money you will not qualify to do a 1031 exchange.
- At the closing, sales proceeds must go to a Qualified Intermediary (QI) and are held in a separate account for the benefit of the seller.
- At this point the seller has 45 days to identify properties for the potential 1031 exchange. This involves written notification to your QI listing the properties’ addresses and/or legal descriptions of the potential replacement properties. (see property identification rules below).
- The seller has up to 180 days from the closing of the relinquished property to actually complete the purchase of the identified replacement property(s).
- To fully defer tax on your capital gain, you must purchase replacement property that is of the same or greater value as the property that has been sold. You can do a partial exchange but with a partial exchange you may be subject to tax.
- To fully defer tax, you must also have the same or greater amount of debt on the new property as the relinquished property. The seller can offset the amount of debt obtained on the replacement property by putting in additional cash in an amount that would be the equivalent to that of the debt.
What Are The Identification Rules and Requirements?
You must identify the property to be received within 45 days after the date you close of the sale of your relinquished property. There are three property identification rules:
- Three Property Rule: You may identify up to three replacement properties of any value.
- 200% Rule: You may identify any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the exchanged properties as of the initial transfer date.
- 95% Rule: You may identify any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.
In a like-kind exchange, both the property you sell and the property you purchase must be held by you for investment or for productive use in your trade or business. Properties are of like-kind if they are of the same nature or character. This definition is very broad. One may exchange land for office buildings, apartment complexes, retail stores, warehouses etc.
What Are Examples of Non-Qualifying Property?
- Property you use for personal purposes, such as your home and your family car.
- Stock in trade or other property held primarily for sale, such as inventories, raw materials and real estate held by dealers.
- Stocks, bonds, notes or other securities or evidences of indebtedness, such as accounts receivable.
- Partnership interests.
- Certificates of trust or beneficial interest.
There are complex rules involved in performing a successful 1031 exchange. If you are considering a 1031 exchange, it is strongly recommended that you consult with your CPA or a qualified exchange intermediary prior to entering into a buy/sell agreement. If you would like a list of qualified 1031 Exchange Intermediaries, please contact us and we would be happy to provide you with some names.
To download our free Wealth Guide on IRC Section 1031 Exchange, click here.