1031 Resources
Six 1031 Exchange Rules
If you are planning to complete a Section 1031 like-kind exchange, you need to be sure
that you know and understand the rules. While there is no substitute for
professional advice, this information will get you moving on your way to completing
your exchange and steering clear of the ire of the IRS.
Before we begin, it is prudent to lay out just exactly what a “1031 exchange” is. This
process gets its name form Section 1031 of the Internal Revenue Code. There are two
sets of rules in this code: one deals with real property (land, buildings, and other
structures) and the other deals with personal property (boats, aircraft, cattle, etc.). This
article relates only to real property.
As it relates to real property, IRS Section 1031 allows holders of business or investment
property to delay paying capital gains on the disposition of their property so long as the
rules are followed. This is a powerful tax and investment strategy as well as estate
planning tool. Theoretically, an investor could continue deferring capital gains on
property until their death thereby avoiding capital gains altogether (although estate taxes
may have to be paid).
Now, on to the rules:
Rule #1 ›
Both the “old property” and the “new property” must be held for
investment or business use
In the early days of like-kind exchanges, getting past the “similar use” rule was difficult.
If you had a two-story brick apartment building that you wanted to exchange, you had to
find another person with a two-story brick apartment building to “swap” with. The two
of you would get together and simultaneously “swap” titles.
In the late 70s and early 80s, T.J. Starker changed all that with a series of court cases that
went all the way to the Supreme Court. These cases cleared the way for Congress to
rewrite code section 1031 in 1991. The resulting code allowed property owners to
exchange any property held for investment or business use for any other property held for
business or investment use. Now, that two story brick office building can be exchanged
for raw land, a warehouse, or even partial ownership of a larger office building.
The only requirement is that the property be for investment or business use.
Section 1031 does make a distinction between investment property and property held for
resale. Generally, “fix and flip” properties do not qualify for tax-deferred exchanges.
Intent is an important component of qualifying your property for favorable exchange
treatment. As such, most industry professionals agree that a holding period of one year
and one day would satisfy the IRS that the property was an investment. The underlying
idea is that by holding the property for this period, you would not be converting shortterm
capital gains into long-term capital gains by completing the exchange. (The IRS
really frowns on attempting to convert short-term gains into long-term gains in these
situations.)
Rule #2 › 45-day identification time limit
From the day that you close on the sale of your old property, you have 45 calendar days
to identify your replacement property. Being calendar days, the limit includes holidays,
weekends, and vacations. This time period is not negotiable and the IRS will not make
exceptions to this rule. Be sure that your Qualified Intermediary (QI) is available when
you are ready to identify if you are getting close to the end of your 45-day identification.
If you go beyond the 45-day limit for your identification and continue with the exchange,
your whole exchange will be disqualified and penalties and taxes are sure to ensue. If
you change your identified property list after 45 days, you (and likely your QI) will go to
prison.
The list that you develop during this period of time has some stipulations associated with
it as well. For starters, if you identify three properties or less, there is no limit on the total
value of property that you can identify. For example, if John sells a building for
$450,000 he can identify $25,000,000 or more in replacement property so long as there
are not more than three properties included in this total dollar value. There is no limit on
the dollar value.
However, if John identifies more than three properties, he is subject to the 200% rule.
This rule states that John cannot identify more than $900,000 ($450,000 X 200%). If he
goes over that limit, the exchange will be disqualified. For obvious reasons, it is best to
keep the list to three or fewer properties in most cases.
Your list is given to your QI whose job it is to receive the list on behalf of the IRS. The
properties on the list must be identified in such a way that an IRS agent could request the
list and drive to each of the listed properties. It is recommended that you give the
complete physical (not mailing) address of each property to be identified. Be sure that
you verify the address before turning in your list.
Rule #3: 180-day purchase time limit
From the date that you close on your property sale, you have 180 days to close on your replacement property. Take note that the identification period and closing period run
concurrently. When your identification period is up, you will only have another 135 days
left to close. The day of closing is when title is officially passed to you. Like the
identification time limit, there are no extensions and no exceptions.
Rule #4 › Use of a Qualified Intermediary
Law requires that you not touch the money between the sale of your old property and the
purchase of your new property. To accomplish this, you must use an uninterested third
party called a Qualified Intermediary (QI). These people are also sometimes referred to
as facilitators or straw men.
The QI has several important roles. As indicated above, the QI is responsible for
handling the identification documents and closing of the transaction. The QI will
facilitate the transfer of funds and title. They will prepare all of the required paperwork.
They also hold the funds between the sale of the old property and the purchase of the new
property.
As you can see, the QI plays a very important role in your 1031 exchange. Any glitch
along the way, whether with identification or closing documents, could disallow your
exchange. For this reason, it is important to be sure that you are dealing with a
professional in this field. No government body regulates Qualified Intermediaries.
Therefore, it is important that your QI be bonded. The fact that the QI is bonded does not
guarantee that your exchange will not be challenged but it does show that the QI has
committed the time, energy, and resources to put some “meat” behind their credentials.
It is also very important to know who cannot serve as your Qualified Intermediary. This
list includes your CPA, attorney, realtor, relative, employee, or business associate. You
must use a completely independent third party.
Rule #5 › Titles must match
The ownership of the old property must match the ownership of the new property. For
example, David Jones owns an apartment building that he wishes to exchange into a
Tenant in Common fractional ownership of an office building. The title document of the
old property shows the owner as “David P. Jones”. David is married and he would like to
share ownership of the TIC property with his wife, Rebecca, with whom he files a joint
tax return. If David adds his wife Rebecca to the title of the new property, the IRS will
deem this transaction to be a sale and subsequent purchase thereby disallowing the
exchange.
However, if David and Rebecca are cousins who own the property together and file
separate tax returns, one or the other could complete an exchange with their portion of the
sale proceeds. The IRS will look to the tax records to identify proper title.
This title requirement can be a bit of a hurdle for estate planning. For this reason, it is
important to speak with an estate attorney regarding your desires for your property
dispositions. Many property owners will seek to turn a business property (such as an
apartment building that they have owned for many years) into an income producing
property with no management duties (such as a TIC triple net investment) in their later
years to produce worry free retirement income. This transaction generally requires some
thought toward estate planning and proper title.
Another important issue to consider is whether or not a trust, partnership, or LLC owns
the property. If one of these entities owns the title of the old property, it must also own
the title to the new property in order for the exchange to be allowed. If only one
participant in the LLC, partnership, or trust decides not to continue with the exchange
process, no one will be allowed to exchange their portion of the proceeds. Once again,
ownership must match and you must reinvest all of the sale proceeds (see Rule #6).
Rule #6 › Reinvestment of sales proceeds
To defer all of the capital gains taxes, you must: 1) purchase a property of equal or
greater value and 2) reinvest all of the cash proceeds from the sale. Forget what you have
heard about taking on as much or more debt in the new property. Let’s take a look at a
couple of examples to clarify this point.
Example #1: David decides to sell a piece of property that he has owned for several
years. The property has the following capital structure:
Sales price: $300,000
Mortgage Debt: $100,000
Cash to Intermediary $200,000
David buys a new property for $425,000 using all of the $200,000 cash from the QI and
adding mortgage debt of $225,000. David has met the reinvestment rules for this
property.
Example #2: Using the same sales figures from above, David buys a new property for
$225,000. David reinvests all of the cash from the QI and adds mortgage debt of $25,000
to the property. David has violated part of the reinvestment rule by buying a less
expensive property than that which was sold. The taxable gain (called “boot”) in this
case is $75,000 ($300,000-$225,000), the difference in the sales price of the old property
and the purchase price of the new property.
Likewise, if David purchases a new building for $350,000 but only uses $175,000 of the
cash from the QI, the excess cash ($25,000) is taxable as boot.
Notice that neither of these cases causes the entire exchange to be disqualified. David
simply does not maximize the tax deferral on his transaction.
