The IRS has three mandated rules that you must follow in regards to identifying your next property for the 1031 exchange to be valid:
• You may identify up to three replacement properties of any value.
• You may identify more than three replacement properties as long as the fair market value (FMV) of those properties does not exceed 200% of the sales price of the relinquished property.
• If you exceed the rule of only identifying up to three replacement properties and you exceed the 200% rule, the exchange could still be legal if you purchase 95% of the aggregate FMV of all identified properties!
Furthermore, identification MUST:
• Be in writing
• Have detailed information identifying the property. Complete address and legal description are required.
• Be signed by you.
• Be delivered to your qualified intermediary by the 45th day – no exceptions!
Please keep in contact with your QI regarding the identification period to help you with the rules. Do not be afraid to ask a lot of questions!
New property must be like-kind!
The IRS stipulates that a 1031 Exchange is a like-kind exchange. This does not mean that if you are selling a residential investment property you cannot purchase a commercial investment property – or that since you own a ranch (Single Level) that you can’t buy a Two Story Investment Property! In Real Estate, like-kind simply means buying more real estate that you will hold for a productive use in trade, business or investment property.
Value requirements!
In order to experience the full tax benefits of the 1031 Tax-Free Exchange, you need to obey the following guidelines:
• Purchase a replacement property more expensive than the relinquished property … AND
• Have a mortgage (leverage) on the new property for at least the same amount as what was on the relinquished property … AND
• Spend all the equity that was received from the sale of the relinquished property.
If you follow all of those guidelines, then your Exchange should have no capital gains tax liability.
However, if you do not meet all of the above requirements, it doesn’t mean the entire transaction is taxed … it just means you are taxed on the difference. This would be considered a partial 1031 exchange, which is perfectly legal. The difference in the purchase price, mortgage indebtedness or equity is called a boot or “unlike-kind property” and is taxable to the recipient.
Creating a boot is an expensive event! Please be sure this is what you want to do! You will have to pay Federal and State Capital Gains Taxes on the amount of Cash or Boot received, plus 25% of the depreciation recapture!
Please verify any information that you read in this website with qualified professionals who are up-to-date and specialized in those respective fields. Rules are always changing, so it is imperative that before you make any investment decisions you speak with the appropriate professionals!
You must use a qualified intermediary to make a purchase!
As you recall, your QI is holding your funds for your new purchase. When you are ready to buy one of the identified properties, you must include in the offer to purchase that the purchase is a 1031 Exchange. The QI will again create an arm’s –length transaction to accept the property from the seller in the QI’s name and then convey the Title to you by deed. The QI will also provide the funds for the closing and will work with all parties involved to ensure that you complete the 1031 Exchange in an appropriate manner.
The Exchange Period – Very Important!
According to the IRS, the Exchange Period is the period within which the person who has Sold the relinquished property must receive or close on a new, properly identified replacement property! The Exchange Period ends exactly 180 days after the date that you closed on the relinquished property or the due date for your tax return for the taxable year in which the sale of the relinquished property occurred – whichever is sooner.
Again, the IRS is very strict with this deadline. It doesn’t matter if the 180th day falls on a weekend or legal holiday … you must adhere to this time frame!
Miscellaneous tidbits!
• Flipping investment properties may be considered dealing in the eyes of the IRS and therefore, would not qualify for a 1031 exchange.
• According to experts, the IRS has not stated the exact amount of time that you must hold a property before you can sell it using the 1031 exchange. Most experts advise at least 1 year to avoid being considered a dealer. Please verify this!
• The IRS has clarified that in the case of a related-exchange (an exchange with anyone related to you by blood or marriage) that the property must be held for a period of 2 years.
• Please check with your accountant or CPA to learn additional information regarding the transferring of depreciation from the relinquished property to the replacement property. Also, ask how the cost basis is figured!
