Understanding the key 1031 tax exchange rules is the first step you should take if you are considering using 1031 to defer capital gains taxes and depreciation recapture.
Here are seven key 1031 tax exchange rules that will get up to speed on the most important factors in 1031 exchange.
What Is A Section 1031?
Section 1031 is from the IRS Code and is the name of the section where 1031 tax exchange rules are discussed. It permits an investor to sell certain types of real estate by replacing it with what is called like-kind property.
In doing so, the investor is able to defer capital gains taxes, which will be due again when the property is sold (unless the investor uses another 1031 upon the sale of the investment property).
What Property Qualifies For A 1031 Exchange?
The IRS rules that only like-kind properties may replace the property you are selling. Like-kind properties in real estate mean that an office building may serve as replacement property for a shopping center or a warehouse, but not for land.
To qualify for a Section 1031 exchange, the property being disposed of (the relinquished property) must have been used in the exchangor’s trade or business and/or must have been held for investment purposes.
The property being acquired (the replacement property) must likewise be acquired for use in the exchangor’s trade or business or for investment.
What Property Is Not Included?
All types of commercial property may be exchanged for a like-kind property in a 1031 exchange.
However, if you plan on including personal property in the exchange, you will need to be very careful. The 1031 tax exchange rules for personal party, as in stocks, bonds, LLC interest, and personal residences are much more complex.
Who Can Use A 1031 Exchange?
The 1031 tax exchange rules require that the taxpayer who sells the property and the taxpayer who buys the like-kind property be the same person.
If you’re an individual taxpayer then that’s a question that is easily solved. However, this can present a problem when there is a limited liability company that has more than one member, yet not all members want to use a 1031 exchange.
In this case, you would need to dissolve the LLC and then declare all investors tenants in common; those members who want to use a 1031 exchange can begin the process, while those who do not would cash out and pay taxes.
Are There Any Time Limitations?
Once you sell your commercial income property, you have 45 days from the close of the sale to identify in writing up to 3 replacement properties.
If you would like to purchase more than 3 properties, then the 200% rule applies, which states that the market value of all of the properties may not be more than two hundred percent of the property that was sold.
As an investor, you needn’t purchase all three properties. You can purchase one, two, or three of the replacement properties you’ve identified. However, once you identify a property, you may not purchase a property that was not previously identified.
Keep in mind that if you identify properties whose value is more than 200% of the property that was sold, it will be considered as if no properties were identified – and you will be liable for paying capital gains taxes.
Therefore it’s a good idea to make sure you identify properties whose value is definitely under the market value of the property that was sold. That way, if a property is later assessed and found to have a higher market value, you will have some leeway.
The next time limit is the 180-day rule, which states that you have 180 days from the close of the property that was sold to purchase any properties that were identified in the initial 45 day period.
Do I Need To Use All Of The Profits Of The Sale In My 1031 Exchange?
Any proceeds you receive from the sale of your relinquished property, along with the Net equity and remaining mortgage are considered proceeds.
When referring to “using all” of the proceeds, IRS 1031 tax exchange rules make it clear that simply reinvesting the net equity of your relinquished property isn’t enough.
Your replacement property must cost as much or be more than the total net equity received when you sold your relinquished property.
So for example, if you sold a relinquished property for $1.7 million, and there was a mortgage of $800,000, then you must purchase a replacement property for the full $1.7 million, not just $900,000.
You can only use the proceeds of the sale once the 1031 exchange is finished, expires, or fails.
When Can I Use The Unused Proceeds Of The Exchange?
Proceeds from the sale of the relinquished property may be accessed only when the exchange is completed.
If for some reason you are unable to identify one or more replacement properties within 45 days or have not completed the purchase of the properties within 180 days, then the exchange has failed, and you may receive the funds. They will, however, be taxed.
Consult with a certified accounting professional or a tax attorney when planning on a 1031 exchange. Please check with your own professional team before acting on any advice stated here.