Investors use 1031 exchanges to sell existing properties and purchase new ones at the same time, like a swap. A 1031 Exchange is an excellent way to save money by deferring the capital gains tax on the property you are selling.
To qualify for a 1031, you will need to prepare the property you intend to sell and identify the replacement property you intend to purchase. The guidelines state that you may identify up to three properties in the exchange. Still, exceptions to this rule will allow you to identify more.
Read on to learn more about 1031 exchanges, how they work, and how many properties you can identify in a 1031 exchange.
In other words, you will not need to pay taxes on the profit you made from selling the first investment property in exchange for your investment in the replacement property. Instead, you will pay these taxes when you eventually sell the replacement property in a non-1031 exchange transaction.
1031 Exchanges got their name from IRC Section 1031, which describes the rules for completing the exchange. The IRS and others also refer to 1031 Exchanges as “like-kind exchanges.”
What is a Reverse 1031 Exchange?
A reverse 1031 exchange occurs when you purchase your replacement property before selling the existing property.
In this case, you will need to identify the property you intend to sell within 45 days of closing on the replacement property. You will also need to complete the entire transaction within 180 days of closing on the replacement property in order to qualify for the benefits of a successful 1031 exchange.
How Many Properties Can You Identify in a 1031 Exchange?
Most investors swap two properties via a 1031 exchange – an old property is sold and replacement property is purchased. However, you can identify up to three properties in a 1031 exchange.
Once you identify the three properties you intend to sell, you can identify up to three replacement properties. When the time comes, you can purchase however many of the three identified replacement properties as you wish. Ultimately, the total value of the real estate on each side of the exchange must be comparable, or like-kind. Thus, your three sold properties could be exchanged for one replacement property that is about equal to the total value of the three you just sold.
This is referred to as the “3 Property Rule” because it limits you to including three properties in the 1031 exchange
How Do You Identify Properties in a 1031 Exchange?
Once you are ready to identify your properties, follow the 1031 identification rules to correctly identify the properties.
What to Include in Property Identification
Your property identification should include the following items:
- A clear description of the potential replacement property
- Percentage share of property being acquired if under 100%
- Signature of taxpayer
The property must be unambiguously described. The best way to ensure you meet this requirement is to include the complete property address (including unit numbers) and the legal description of the property.
You will also need to include a description of what will be constructed on the property if you identify a property under construction as your replacement property.
You must identify the properties involved in the exchange in writing. Once it is completed, you will need to sign the identification.
All involved parties must agree and sign off on the written identification of the properties. Note that your real estate agent and those related to you are considered disqualified persons, meaning they are *not* qualified to sign.
You will also need to complete IRS Form 8824 to report your 1031 exchange to the IRS to further secure your transaction.
Where to Send Identification
You will most likely work with a “Qualified Intermediary” to identify the properties involved in your 1031 Exchange. These are independent people, companies, or entities that function similarly to escrow agents to facilitate the 1031 Exchange.
You could also send your written identification to the person transferring any replacement properties to you or to any other people involved in the transaction. You cannot meet the requirement by notifying a disqualified person (your real estate agent or relatives).
Despite the 3 Property Rule, there are ways that you can identify more than three properties in one 1031 exchange. These exception rules are known as the “200% Rule” and the “95% Rule.”
The 200% Rule
The 200% rule allows you to identify over three replacement properties as long as their total value does not exceed 200% of the aggregate fair market value of the property you are selling.
You will need to identify properties with lower values than the 1031 Exchange rules require. This is a best practice because sometimes properties are assessed at a higher value than your initial estimate.
The properties will no longer be eligible for the 1031 exchange if their assessed values come in higher than 200% of the fair market value of the first property. Factor this in when planning your exchange to ensure the real estate value of each property does not exceed your estimated value by the completion of the 1031 transaction.
The 95% Rule
The 95% rules allow you to purchase more than three properties that total over 200% of the fair market value of the property you sold. To qualify, you must acquire at least 95% of the total value of each replacement property you identify.
Investors do not often use this exception because most will not acquire 95% of each replacement property identified in the 1031 Exchange.
How Long Do I Have to Complete the Exchange After I Identify the Properties?
You should be aware of the 1031 Exchange deadlines once you are ready to start the process.
It is essential to note that these deadlines run concurrently. In other words, they both start on the day you close the sale on the first property you are selling.
45 Day Rule
You have 45 days from the closing date of the property you are selling to identify the property you will be replacing it with during the 1031 exchange.
Suppose you are relinquishing multiple properties in one exchange. In that case, this 45-day period begins on the date that the first sale closes.
You do not need to be in a contract for the replacement property within these 30 days. You just need to identify which property you will purchase. Please note that once you do this, you cannot change your mind and acquire a different property in the exchange.
180 Day Rule
You have 180 days from the day you close the sale on the property you are selling to complete the entire 1031 exchange. This includes selling and purchasing all properties identified in the 1031 exchange.
Remember that the 180-Day period and 45-Day identification period begin on the same day. The 180 Day rule does not start at the end of the 45 days.
Deadlines for Reverse 1031 Exchanges
The deadlines remain the same for reverse 1031 exchanges. However, the 45-day identification period and 180-day periods will begin when you close on the replacement property instead of the date you close on the relinquished property.
What Type of Properties Can You Identify in a 1031 Exchange?
A 1031 exchange can only be used in the following situations:
- The properties being exchanged are “like-kind”
- The properties are business or investment properties
- The properties are not your vacation or primary homes
Like-kind properties are similar properties (regardless of quality or grade).
In a 1031 Exchange, these properties must be held for investment, trade, or business purposes.
Business and Investment Properties
1031 Exchange properties must be business or investment properties.
Business properties are purchased for use in business or trade. These properties are purchased to make money rather than provide a residence for the owner(s).
Investment properties are real estate properties purchased to generate a profit. These properties can be held by a single investor, a group of investors, or a corporation. Most investment properties generate returns through a resale later or via rental income.
Vacation homes do *NOT* qualify for a 1031 exchange.
Previously, a loophole allowed you to shield up to $500,000 in capital gain from taxes by using a 1031 exchange. You could do this by swapping one vacation home for another, moving there later, and living there for two out of five years in retirement.
Congress closed this loophole in 2004. However, you can still include vacation homes in 1031 exchanges if you turn them into rental properties. To qualify, you would need to rent out the vacation home for 6 months out of the year. You must actually have tenants, not just simply list the property for rent.
If you are unsure if this applies to you, chat with your tax and/or legal adviser about your specific situation.
Primary residences do *NOT* qualify for a 1031 exchange. The exception to this rule is if you rent out your home for 6 months or more of the year. It would then become an investment property, and you could include it in a 1031 exchange.
In addition to the restrictions above, 1031 exchanges do not apply to the following types of property:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
Additionally, you must acquire “substantially the same” property you identified in your 1031 Exchange. This means the property you end up with must be of the same nature and character as you specified in the exchange.