The Rules of 1031 Tax Exchange

1. Property must qualify for a tax-deferred exchange.

As mentioned earlier, personal residences and inventory properties do not qualify for a 1031 exchange.

2. The investor must state that he is planning to do a tax-deferred exchange prior to the sale of the current property.

3. The exchange must be for “like kind” property.

This is defined in the IRS Code as “any form of real estate used in a trade or business or held for investment”. Note that you can not exchange real property (real estate) for investments like stocks or bonds.

4. For property to qualify as either a relinquished or replacement property, it must be held for investment.

The word held has caused thousands of court cases. Nowhere in the law does it specify exactly how long a taxpayer is supposed to have held (owned) the relinquished property before selling it as part of a 1031 exchange. Until a court clarifies this issue, it would be wise to assume a least one full year of ownership. The law is more specific in cases of “Related Exchange” where the taxpayer has either a marriage or blood relationship or owns a significant partnership or corporate interest. Two years is required for this exchange. Using caution as a guide, an investor would be advised to hold his acquired replacement property for a minimum of a year before selling it, but one should always consult with an experienced competent CPA or attorney before moving forward with any questionable sale.

5. To avoid tax consequences in an exchange, all of the cash proceeds and at least the same amount of debt that was paid off must be reinvested in the replacement property.

If additional cash is needed to acquire the replacement property, the investor can provide the funds at closing. However if any of the cash from the relinquished property is not used or if the debt mortgage is less than the previous amount, then the amounts not reinvested will be subject to tax. The unused cash or debt is referred to as the “boot”.

6. The exchange transaction must be technically structured as an exchange, not merely the sale of one property and the purchase of another.

The mechanics of this fall to the role of the Qualified Intermediary (QI).

7. The 45 Day Rule.

The day the relinquished property closes (and distribution takes place) the clock is started on a 45 day countdown. The replacement property must either be closed or identified within the 45 day period. Since it may not be practical for the taxpayer to close on his desired property (properties) within 45 days, he merely has to identify what properties he plans to purchase. The taxpayer will be allowed a total of 180 days to fully complete the transaction from the time the relinquished property closes (45 days to identify and 135 days to close equals 180 days). After the 45 days period has passed the taxpayer may not change the list of identified properties and must purchase some or all of the identified properties. The identification must be reasonably specific using a good legal description to define the properties.

8. Three Property, 200 Percent and 95 Percent Rules.

These rules apply only when a taxpayer identifies replacement properties. If the taxpayer is able to purchase all replacement properties within the 45 day clock time period, these rules do not apply.

1. If you identify no more than three properties, the replacement properties may be of any value, individually or collectively. Properties acquired during the 45 day period count toward the three property rule and limit how many properties should be identified.
2. If the taxpayer identifies more properties than allowed by the three property rule, the total value of all purchased replacement properties may not exceed 200 percent of the total sales price of all relinquished properties.
3. If the taxpayer identifies more properties than allowed by the three property rule and the 200 Percent rule has been exceeded, the taxpayer MUST purchase enough replacement properties to equal at least 95 percent of the fair market value of the identified replacement properties. The intent of this rule is to limit the number of properties that are identified and close on only those that are most convenient.

9. The 180 Day Rule.

The identification and acquisition processes start the day after the closing of the relinquished property. This is the starting point for both the 45 and 180 day time periods. For any sale of relinquished properties in the 1st half of the year, the 180 day rule is simple. For closings after early July, especially those in late October, November or December, particular care may need to be taken. The rules specify that if you can identify, you are allowed 180 days to close the replacement property OR up to the date that year’s income tax return is due (April 15 for individuals, earlier for corporate and partnership accounts). A solution to consider is to file for an extension of the income tax return, giving more time to close the replacement property. No extensions are allowed under the 180-day rule. Investors were not granted any additional time even following massive natural disasters.

10. Proceeds of Sale of the Relinquished Property.

Any money resulting from the sale of the relinquished property not invested in the replacement property will go to the taxpayer. It is called boot and is taxable to the recipients in the year received. Any money received by the taxpayer is taxable but will be partially offset by deductible closing expenses. If the taxpayer does not create a mortgage on the replacement property larger than paid off on the sale of the relinquished property the difference in the mortgage amounts is boot also. In order to purchase a more expensive replacement property, the taxpayer must use a mortgage or personal funds to close the purchase.