June 03, 2021
To successfully follow the 1031 exchange rules, you need to meet the following requirements:
1. Purchase a property of equal or greater value
2. Reinvest all the equity into a replacement property or properties (any equity not reinvested is taxable income called "boot")
3. Obtain equal or greater debt in the new investment(s) or invest more equity
All 1031 exchanges must be between Like-Kind property and under an ownership structure that qualifies. A Like-Kind trade is between properties similar in nature or character, regardless of differences in grade, property type, or quality. Below is a select list of property types that could be transferred in a like-kind exchange for any of the following property types.
- Unimproved land
- Apartment building
- Office building
- Industrial building
- Retail building
- Single tenant NNN lease
- Delaware Statutory Trust (DST)
- TIC properties
Below is a table of ownership interests that qualify and do not qualify for a 1031 exchange.
Examples of Interests that Do Not Qualify
Land under development for resale
Property purchased for resale
Stock in a REIT (except an UPREIT-IRS Section 721 Exchange)
Foreign real property for U.S. real property
|Examples of Interests that Qualify||Examples of Interests that Do Not Qualify|
|30 Year+ Leaseholds||Land under development for resale|
|Water rights||Property purchased for resale|
|Mineral rights||Stock in a REIT (except an UPREIT-IRS Section 721 Exchange)|
|Oil & Gas interests||Foreign real property for U.S. real property|
|Raw land and Farmland|
|Mitigation credits for restoring wetlands|
A Like-Kind trade is between properties similar in nature or character, regardless of differences in grade, property type, or quality.
Here is an example of a 1031 exchange. Two investors sell a property for the same value of $10,000,000. However, one investor does not use equal or greater debt and will be subject to taxes.
The example above illustrates the need to match leverage between investments. Although the wrong investor used all their equity, they used $3,000,000 less debt. If this occurred, the investor would be responsible for taxes on the $3,000,000 difference.
Before the 1031 exchange process can begin, the exchanger needs to engage a Qualified Intermediary. A Qualified Intermediary holds the sales proceeds in an account where the money will not be used for anything other than the exchange. If the money is not transferred to an escrow account managed by a Qualified Intermediary, then the IRS will tax the gain since the exchanger “obtained” the funds. Even if the exchanger never receives the money, sales proceeds outside of a Qualified Intermediary is constructive receipt, therefore, taxed as if the exchanger took possession of the funds.
1. Exchanger selects Qualified Intermediary and opens an escrow account
2. Sale proceeds are deposited into the escrow account
3. Funds are released from the escrow account to purchase the replacement property
4. Exchanger closes on the replacement property and completes the exchange
|Day 1||The property is sold|
|Day 45||The exchanger must identify all potential properties for purchase by this day|
|Day 180||The last day to complete and record the purchase of exchange property or properties|
IRS Section 1031(a)(3)
- You have 45 days from the sale date to identify replacement property/properties
- You can only exchange into the properties that you identify during the 45-day period
- The Qualified Intermediary keeps track of all identified properties
The exchange must be completed at the earlier of:
- 180 days after the sale of the original property
- The due date of the income tax return, including extensions, for the tax year that the property was sold
The Exchanger may choose one of the three options below:
3 Property Rule: You can select up to 3 properties, regardless of their market value
200% Rule: You can identify as many properties as you want if the fair market value of the selections does not exceed 200% of the sale price of your property
95% Rule: You can identify as many properties as you want if you purchase 95% of the total value you identified
Disclaimer: The information contained in this article is provided for general informational purposes only, and should not be considered or treated as legal or tax advice and represents only general information that may or may not be applicable to the reader’s particular situation. The reader should consult its own attorney and/or tax advisor if specific guidance, information, or advise is required.