1031 Exchange Rules for Investment Properties
If you own investment property and have sizeable capital gains and are considering selling, you should know about the 1031 tax-deferred exchange. Under Section 1031 of the United States Internal Revenue Code (26 U.S.C.§ 1031), a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property, a process known as a 1031 exchange. The properties exchanged must be of “like kind”, i.e., of the same nature or character, even if they differ in grade or quality. Real properties generally are of like kind, regardless of whether the properties are improved or unimproved. However, a real property within the United States and a real property outside the United States would not be like-kind properties. Generally, “like kind” in terms of real estate, means any property that is classified real estate in any of the United States.
Identification and Time Limits
The §1031 exchange begins on the earliest of the following:
- the date the deed records, or
- the date possession is transferred to the buyer,
- 180 days after it begins, or
- the date the Exchanger’s tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.
The identification period is the first 45 days of the exchange period and the replacement property(ies) within 180 days. If the Exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason, except for the declaration of a Presidentially declared disaster.
In order to qualify for this exchange, certain rules must be followed:
- Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
- The asset must be of like-kind. Real property must be exchanged for real property, although a broad definition of real estate applies and includes land, commercial property and residential property. Personal property must be exchanged for personal property. (There are some complicated rules surrounding this — for example, livestock of opposite sex are not considered like-kind property for the purpose of a 1031 exchange, and property outside the United States is not considered of “like-kind” with property in the United States.)
- The proceeds of the sale must be re-invested in a like kind asset within 180 days of the sale. Restrictions are imposed on the number of properties which can be identified as potential Replacement Properties.
More than one potential replacement property can be identified as long as you satisfy one of these rules:
- The Three-Property Rule – Up to three properties regardless of their market values. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
- The 200% Rule – Any number of properties as long as the aggregate fair market value of all replacement properties does not exceed 200% of the aggregate Fair Market Value (FMV) of all of the relinquished properties as of the initial transfer date. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
- The 95% Rule –Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified. In other words, 95% (or all) of the properties identified must be purchased or the entire exchange is invalid. An exception to the 95% rule is that if you close on a property within the 45 day period it still qualifies for the exchange.
Under section 1031, if the seller is to take constructive receipt of the proceeds from the sale of the relinquished property they will incur a tax event. For that reason, proceeds from the sale must be transferred to a qualified intermediary, and the qualified intermediary coordinates with escrow to transfer funds to the seller of the replacement property or properties and complete the exchange. A qualified intermediary is a person or company that facilitates 1031 exchanges by holding the sale proceeds involved in the transaction until they can be transferred to the seller of the replacement property.
The term “boot” is used in discussing the tax implication of a 1031 exchange. “Boot received” is the money or fair market value of “other property” received by the taxpayer in an exchange. There are many ways for a taxpayer to receive “boot”, even inadvertently. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided.The most common sources of boot include the following:
- Cash boot taken from the exchange. This will usually be in the form of “net cash received”, or the difference between cash received from the sale of the relinquished property and cash paid to acquire the replacement property(ies). Net cash received can result when a taxpayer is “Trading down” in the exchange (i.e. the sale price of replacement property(ies) is less than that of the relinquished.)
- Debt reduction boot which occurs when a taxpayer’s debt on replacement property is less than the debt which was on the relinquished property. As is the case with cash boot, debt reduction boot can occur when a taxpayer is “trading down” in the exchange. Debt reduction can be offset with cash used to purchase the replacement property.
- Sale proceeds being used to pay non-qualified expenses. For example, service costs at closing which are not closing expenses. If proceeds from the sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer had received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their property to pay for the following: non-transaction costs i.e. rent prorations, utility escrow charges, tenant damage deposits transferred to the buyer, and any other charges unrelated to the closing.
- Excess borrowing to acquire replacement property. Borrowing more money than is necessary to close on replacement property will not result in the taxpayer receiving tax-free money from the closing. The funds from the loan will be the first to be applied toward the purchase. If the addition of exchange funds creates a surplus at the closing, all unused exchange funds will be returned to the Qualified Intermediary, presumably to be used to acquire more replacement property. Loan acquisition costs (origination fees and other fees related to acquiring the loan) with respect to the replacement property should be brought to the closing from the taxpayer’s personal funds. Taxpayers usually take the position that loan acquisition costs are being paid out of the proceeds of the loan. However, the IRS may take the position that these costs are being paid with exchange funds. This position is usually the position of the financing institution also. Unfortunately, at the present time there is no guidance from the IRS on this issue which is helpful.