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Internal Revenue Code Section 1031 is one of the single greatest wealth building tools available to the real estate investor.
Internal Revenue Code Section 1031 allows investors to defer the payment of capital gains taxes when selling an investment property and exchanging into another investment property.
The Exchange Process – Four Simple Guidelines
Strict adherence to the legal requirements of Section 1031 of the Internal Revenue Code is required for a successful exchange. Investors should be aware of four basic requirements when entering into a delayed exchange and should seek the advice of a tax accountant or attorney to ensure proper adherence to the tax code. The four basic
requirements for a successful exchange are:
The Internal Revenue Code states that the properties involved in an exchange must be held for productive use in trade or business or for investment and they must be like-kind.
The IRS provides a maximum of 180 days to complete an exchange. The timeline begins upon the close of escrow (COE) of the relinquished property. The new property (or properties) must be acquired on or before midnight of the 180th day. No Exceptions! In addition, the IRS requires that all potential replacement properties be identified by midnight of the 45th day of the exchange.
Identification of all potential replacement properties is required on, or before, day 45 of the exchange. Identification must be in writing and the description of the properties must be unambiguous. The IRS provides two rules for identifying replacement property:
The 3 Property Rule
The 3 Property Rule allows for identification of any three properties, of any price, anywhere in the United States.
The 200% Rule
The 200% Rule is an option for identifying more than three properties. With the 200% Rule, four or more properties can be identified. However, the combined value of all properties identified cannot exceed 200% of the property sold.
To defer 100% of the capital gains tax liability, two requirements must be met:
Reinvest all the Cash
All the cash that was generated from the sale of the relinquished property must be reinvested into the new property or properties.
Purchase Equal or Greater in Value
The new property, or properties, must be equal or greater in value to the property sold.
Types of Exchanges
In a simultaneous exchange, the relinquished property is sold and the replacement property is acquired on the same day, with concurrent closings. The simultaneous exchange is rare and investors should still use an Exchange Accommodator when doing a simultaneous exchange.
The most common method of exchanging, the delayed exchange, allows investors to sell a property and then acquire replacement property within 180 days.
The reverse exchange allows investors to acquire replacement property prior to selling. The reverse exchange can be more complicated however, as investors cannot own both the new replacement property and (soon to be) relinquished property at the same time.
The construction exchange allows investors to use exchange proceeds to build on land or improve an existing property. The construction/improvement exchange is often used to acquire a fixer and do improvements on the existing structure. Not all clients qualify for a construction exchange, so please contact the exchange company of your choice to discuss the process.
Frequently Asked Questions
Q: How long do I have to own a property before I can exchange it?
A: The longer the better. Unfortunately, there is no safe holding period for property to automatically qualify for an exchange. Keep in mind. the property only needs to be “held for investment” for it to be eligible for an exchange. Time of ownership is only one factor the IRS looks at when determining if the property was “held for investment”. Some tax advisors recommend a minimum holding period of one year.
Q: Can I sell my duplex and purchase raw land?
A: Certainly. Properties involved in an exchange need to be held for either productive use in trade or business or for investment. Holding land for future appreciation is considered held for investment. Do not get confused by the “like kind” requirement. “Like kind” can be any real property used for business or investment purposes within the U.S.
Q: Can I buy my replacement property first?
A: Yes. This requires a reverse exchange. A reverse exchange may be an option provided it is structured according to the safe harbor guidelines.
Q: Can I move into a rental property that was originally purchased as part of a 1031 Exchange?
A: Yes. However, please keep in mind that the IRS will look at your “intent” in determining if your exchange is valid. If the IRS feels your original intent when the property was initially acquired was to use it as a primary residence, you may have your exchange disqualified. We recommend renting a property out for at least 2 years before using it for personal use.
Q: Do I have to reinvest ALL of my cash (equity)?
A: No. However, any cash (equity) that is not reinvested in real estate will be taxable (and is known as cash boot). The general rule of thumb, if you don’t want to pay any taxes, is to reinvest all of your cash and purchase a property equal or greater in value.
Q: How long do I have to complete my exchange?
A: 180 days. However, also keep in mind you will be required to identify your potential replacement properties on day 45 of your exchange. Your timeline starts when you close escrow on the property you are selling.
Q: How do get my exchange started?
A: Call the exchange company of your choice once you’ve opened escrow. They will draft up an exchange agreement and coordinate with you and your escrow company to facilitate the exchange.
The content provided is a courtesy of The Official 1031 Exchange Guidebook from Asset Exchange Company and is meant for general information purposes only. It does not, and is not intended to, constitute tax and legal advice. Investors should consult accountants or lawyers to ensure proper compliance with laws.
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