Concise Overview of 1031 Tax Deferred Exchanges

There is a lot of information on the Internet regarding tax-deferred exchanges and it can be very confusing to sift through all of the details to determine what is correct versus what is not so correct.

This post is designed to give you a very quick, concise overview of the 1031 exchange. It is only a brief summary to assist Investors in understanding the very basic 1031 exchange requirements. You can read an Introduction to Section 1031 Tax Deferred Like-Kind Exchanges for a more complete and indepth explanation.

The first thing to look at is whether the 1031 exchange is right for you. It may not always the right or best solution depending on your specific circumstances. Investors should consider whether other tax deferral or tax exclusion strategies might be more appropriate and should always consult with their legal, tax and financial advisors before entering into any real estate transaction, especially a 1031 tax deferred exchange.

1031 Exchange Requirement

The sale and the purchase transactions must be structured properly in order to qualify for tax-deferred treatment under Section 1031 of the Internal Revenue Code. The Qualified Intermediary often referred to in the real estate industry as the 1031 Exchange Accommodator or the 1031 Exchange Facilitator will complete the necessary legal documents to ensure that you are in compliance will all laws, regulations and rulings.

It is critical that the Qualified Intermediary be be assigned into the Purchase and Sale Agreement or Contract and the Escrow Instructions, if any, prior to the close of the sale and purchase transactions. If either transaction closes without the Qualified Intermediary involved the transaction will not qualify for 1031 exchange treatment.

Reinvesting or Replacing Values

Investors must acquire one or more like-kind replacement properties that are equal to or greater in net purchase value than the net sales value of the relinquished property, must reinvestment all of the net cash proceeds from the sale of the relinquished property, and must replace the same amount of debt that was paid off on the sale of the relinquished property with equal debt on the like-kind replacement property. The Investor can always put more cash into the purchase of his like-kind replacement properties, but can not pull any cash out of the transaction without incurring depreciation recapture and/or capital gain income taxes.

Qualified Use Requirement

The relinquished property and the like-kind replacement properties must have been held as rental, investment or business use property. The critical issue is that the Investor must have held or has the intent to hold the properties for investment purposes.

Like Kind Property Requirement

There is a lot of misinformation regarding like-kind property. It is not true that if you sell a condo you must acquire a condo, etc. As long as you meet the qualified use requirement discussed above any kind of real estate held for investment is like kind to any other kind of real estate that is also held for investment.

You can exchange out of or into any of the following asset types: single family, multi-family, commercial office, retail shopping, industrial, vacant land, oil and gas interests, mineral rights, and tenant-in-common investments.

Multiple Assets and Fractional Interests

The 1031 exchange allows Investors to easily reposition, diversify or consolidate their investment real estate portfolios. They can sell one relinquished property and diversify their portfolio by acquiring multiple like-kind replacement properties, or they can sell multiple relinquished properties and consolidate their portfolio by acquiring fewer like-kind replacement properties. You can also sell or purchase fractional (partial) interests in property.

1031 Exchange Structures

The most common 1031 tax deferred exchange is a forward, or delayed, 1031 exchange where the Investor sells his relinquished property first and then acquire his like-kind replacement property within the prescribed 1031 exchange deadlines.

A reverse 1031 exchange allows the Investor to acquire his like-kind replacement property first and then subsequently dispose of his relinquished property within the prescribed 1031 exchange deadlines.

An improvement (build-to-suit or construction) tax-deferred exchange allows the Investor to use his 1031 exchange funds to acquire like-kind replacement property and to use excess 1031 exchange funds to construct or improve the like-kind replacement property.

1031 Exchange Deadlines

There are very specific 1031 exchange deadlines that must be followed in a forward 1031 tax deferred exchange. The Investor has 45 calendar days from the close of the relinquished property transaction to identify potential like-kind replacement properties being considered for purchase and an additional 135 calendar days — for a total of 180 calendar days — to complete the 1031 tax deferred exchange by acquiring some or all of the identified like-kind replacement properties.

1031 Exchange Identification Requirements

Investors must identify their potential like-kind replacement properties to their Qualified Intermediary within the 1031 exchange time limits discussed above. The identification must comply with one (1) of the like-kind replacement property identification rules outlined below:

Three (3) Property Identification Rule

The three (3) property identification rule is the most common and is used in most 1031 tax deferred exchange transactions. This rule allows the Investor to identify up to but not more than three (3) potential like-kind replacement properties. It is highly advisable for the Investor to identify three (3) properties even if the intent is to only acquire one. If the Investor is looking to diversify his investment real estate portfolio and needs to identify more than three potential like-kind replacement properties one of the following two rules should be considered.

200% of Fair Market Value Identification Rule

The 200% of fair market value rule allows the Investor to identify more than three (3) potential like-kind replacement properties as long as the total fair market value of all the potential like-kind replacement properties identified does not exceed 200% of the sales price of the relinquished property(ies).

95% Exception to Identification Rules

The 95% exception to the identification rules allows an Investor to identify as many like-kind replacement properties as they wish provided they actually acquire and close on 95% of the fair market value actually identified.

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