What’s a 1031 Exchange? Definitions, Requirements, and Timelines
Real estate investments are a strategic way to grow and diversify your portfolio. 1031 exchanges streamline this process, through a qualified intermediary and their network. 1031 exchanges were first authorized in 1921. Congress saw that people reinvesting in business assets benefitted economies, and they wanted to encourage more of it. There have been intermittent changes and additions to the regulations that govern 1031 exchanges, most recently in 2001. Here’s what you need to know about how to define a 1031 exchange and what’s legally required for its success.
What is a 1031 Exchange?
In a 1031 exchange, real property that’s “held for productive use in a trade or business or investment” is sold, and the sale proceeds are reinvested into a like-kind property intended for business or investment use. This allows the taxpayer, or seller, to defer the capital gains tax and depreciation recapture on the transaction. That’s why a 1031 exchange is also called a “like-kind exchange” or a “tax-deferred” exchange. The property sold as part of a 1031 exchange is the Relinquished Property. The property purchased is the Replacement Property.
The real property in a 1031 exchange must be like-kind. Investors favor these transactions for their flexibility, since most real estate is like-kind to all other real estate. For example, an office building could be exchanged for a rental duplex, or a retail shopping center could be exchanged for farmland.
1031 Exchange Eligibility Requirements
To be eligible for a 1031 exchange the person or entity must be a US tax paying identity. This includes individuals, partnerships, S-corporations, C-corporations, LLCs, and trusts. However, the same taxpayer who sells the relinquished property is required to purchase the replacement property for a valid exchange.
During a 1031 exchange, neither the taxpayer, nor an agent of the taxpayer, can receive or control the funds from the sale of the property. If a taxpayer has direct or indirect access to the funds, the 1031 exchange is no longer valid. A qualified intermediary is used to hold the proceeds of the Relinquished Property sale until it is time to transfer those proceeds for the close of the Replacement property.
Important Timelines for 1031 Exchanges
All 1031 exchanges regardless of type have a 45-day identification period and a 180-day exchange period.
For a 1031 exchange to be in accordance with IRC § 1031, the taxpayer must identify their potential replacement property(ies) in writing to the qualified intermediary within 45-days of the close of the sale of the Relinquished Property. The replacement property(ies) description(s) must be unambiguous and specific, using a physical address or legal description.
In relation to the 45-day identification period, there are rules that a taxpayer must follow when identifying their potential replacement property(ies). There are three distinct identification rules that the taxpayer can use, and they can choose the appropriate rule for their specific exchange situation. The three rules are as follows:
3-Property Rule: A taxpayer can identify up to three properties without regard to the fair market value of the properties. They must close on at least one of those identified properties for the exchange to be valid.
200% Rule: A taxpayer can identify more than three properties, but the fair market value of all properties combined cannot exceed 200% of the fair market value of the Relinquished property(ies).
95% Rule: A taxpayer can identify infinite properties, the combined value of which exceeds 200% of the value of what they sold, but they must acquire at least 95% of the fair market value of the properties they identify.
All 1031 exchanges have a 180-day time limit starting from the day of the close on the sale of the Relinquished Property. If the taxpayer has not completed the purchase of the Replacement Property before or on day 180, then the exchange is closed, and the taxpayer must recognize and pay taxes on the proceeds from their Relinquished Property sale. There are no extensions or exceptions available.
Protect Your Investment with an Expert in 1031 Exchanges
Working with a qualified intermediary who knows 1031 exchanges inside and out keeps things running smoothly and helps you stay ahead of critical deadlines. Our Blue Note Exchange clients have access to Certified Exchange Specialists and Subject Matter Experts, and in-house communication and coordination. To learn more, contact our team to schedule a consultation.
