Before We Begin
1031 tax-deferred exchanges can be integral to successful real estate investing as a way to scale your portfolio and maximize the benefits to you. However, it’s necessary to fully understand how 1031 exchanges work so you can set yourself up for successful, beneficial transactions. In this article, we’ll cover the basics of how a 1031 exchange works, some of the pros and cons, and how TFS Properties can help you throughout the process.
Why Is It Required to Identify a Replacement Property in a 1031 Exchange?
There are several rules that govern 1031 exchanges – also called like-kind exchanges or tax deferred exchanges. The rules allow a taxpayer to be able to sell an investment property, put the proceeds of the sale into the hands of a qualified intermediary, and purchase a replacement property or group of properties of equal or greater value at a later date, all without paying capital gains taxes on the sale of the relinquished property.
What Are the 1031 Exchange Identification Rules?
However, there are some time limits in place as well as other rules surrounding the exchange process. Let’s review the basics.
The 45-Day Identification Rule
This rule states that a taxpayer has 45 days from the date of sale of the relinquished property to officially identify an appropriate like-kind replacement property or group of properties.Â
The identification must be in the form of a written document that is signed by the relinquished property owner. It must be delivered to the replacement property owner or any other non-disqualified person who is involved in the exchange. Typically the qualified intermediary receives the identification notice. Property identifications can be revoked, as long as they are replaced with a new identification within the 45-day period.
The 3-Property Rule
The owner of the relinquished property can identify up to three properties as potential replacement properties and then choose which one they ultimately wish to purchase – or purchase all of them. Prior to the 1991 rule change that allowed this, taxpayers had to prioritize their identified replacement properties and could only purchase the second property if the sale of the first property fell through due to a situation outside of their control.
The 200% Rule
If the taxpayer wants more than three properties, they can identify and purchase any number of properties so long as the aggregate fair market value of all of the properties does not exceed 200% of the market value of the relinquished property. So, if a taxpayer relinquished a $100,000 property, he or she could purchase 10 properties valued at $20,000 each for a total value of $200,000 and not exceed the 200% rule.
The 95% Rule
This rule is a bit complicated and difficult to adhere to in actual practice. Essentially, it states that if a taxpayer has over-identified in order to meet the two previous rules, the identification will still be considered valid so long as the taxpayer receives at least 95% of the value that was identified. Your accountant and/or tax advisor can explain this rule more thoroughly in the event that it applies to you.
The Incidental Property Rule
This rule states that if there is incidental property involved in an exchange that would typically pass to a buyer in the course of a standard commercial real estate transaction, the incidental property does not have to be separately identified as long as it’s deemed to be worth less than 15% of the primary property’s value.
For instance, let’s say a taxpayer was exchanging his relinquished property for an apartment building worth \$1,000,000, and the building came with an incidental property that includes furniture, laundry machines, and other miscellaneous items that are worth \$150,000 of the total value. Since it’s incidental property, this does not have to be identified separately from the main property and it does not count against the 3-Property Rule.
However...
This rule states that if there is incidental property involved in an exchange that would typically pass to a buyer in the course of a standard commercial real estate transaction, the incidental property does not have to be separately identified as long as it’s deemed to be worth less than 15% of the primary property’s value.
For instance, let’s say a taxpayer was exchanging his relinquished property for an apartment building worth \$1,000,000, and the building came with an incidental property that includes furniture, laundry machines, and other miscellaneous items that are worth \$150,000 of the total value. Since it’s incidental property, this does not have to be identified separately from the main property and it does not count against the 3-Property Rule.
Description of Replacement Property
The description of replacement properties for the purpose of identification must be very specific and follow these rules:
- The replacement property is only properly identified if it is unambiguously described in writing.
- An unambiguous description of real property can be defined as a legal description, street address, or distinguishable name (such as the name of an apartment complex).
- Personal property must be identified with specific descriptions based on the type of property, such as a make and model for a vehicle.
Property to Be Improved
Sometimes, the replacement property will be in a different physical state at the time the new owner receives it than it was when it was identified. Regulations require that the identification of the property must include as much detail as possible about the current state and any intended improvements. Even if the improvements are not completed by the time the sale closes, the exchange can still be considered valid as long as the property itself is not different from what was identified – only the degree of improvement completed can vary.
Who Must Receive the Identification?
As we mentioned, typically a qualified intermediary receives the identification on behalf of the owner of the replacement property. However, it can be sent to the seller directly or given to anyone else involved in the exchange who is not disqualified. Disqualified people include the relinquished property owner’s employees, attorneys, accountants, investment bankers, and real estate agents if they have provided their services at any time during the two-year period immediately before the transfer of the relinquished property.
Summary
1031 exchanges are very valuable tools for real estate investors, but all the rules must be adhered to in order to avoid trouble with the IRS or disqualifying your exchange, which could result in you having to pay all the capital gains taxes right away.
Have questions? Ask a TFS Properties expert here. Want to get started with a 1031 exchange now? Start your exchange here. Want to stay up to date on the 1031 industry and rules? Sign up for updates here.
Source: Accruit.com
