1031 Exchange Process
The 1031 exchange is named after Section 1031 of the U.S. Internal Revenue Code, which allows an investor to avoid paying capital gains taxes after selling an investment property. However, investors must reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or more excellent value.
1031 Exchange Timelines
Starting when the relinquished property closes, an investor has 45 days to identify potential replacement properties. Additionally, an investor has 180 days to acquire the replacement property starting from when the relinquished property closes. Investors use three methods to identify replacement properties:
Identify up to three properties of any value to purchase at least one.
Identify more than three properties with an aggregate value that does not exceed 200% of the market value of the relinquished property.
Identify more than three properties with an aggregate value exceeding 200% of the relinquished property, knowing that 95% of the market value of all properties identified must be acquired.
An additional method used by investors is the reverse 1031 exchange. In a reverse 1031 exchange, an investor must acquire a replacement property through an exchange accommodation titleholder before exchanging the property they currently own. Investors have 45 days to identify what property will be sold as “the relinquished.” After the initial 45 days, investors have 135 days to complete the sale of the specified property and close out the reverse 1031 exchange with the purchase of the replacement property.
1031 Exchange Requirements
To appropriately complete a 1031 exchange, an investor must adhere to the following requirements:
Investment or Business Property Only
A 1031 exchange is only available for investment or business, not personal property.
Like-Kind Property
Like-Kind property means both the relinquished and replacement properties must be of “the same nature or character, even if they differ in nature or quality.”
Greater or Equal Value
To avoid paying taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased to be the same as, or greater than, the property sold.
Must Not Receive Proceeds or “Boot”
An investor cannot receive the proceeds from selling their relinquished property or “Boot.” Any “Boot” received is taxable to the extent of the gain realized on the exchange.
Same Investor
The name appearing on the title of the property sold must be the same as the tax return and titleholder purchasing the new property.
The Role of Qualified Intermediaries
Under section 1031 of the U.S. Internal Revenue Code, proceeds from a property's sale remain taxable. Therefore, proceeds from the sale of an investor’s property must be transferred to a qualified intermediary rather than the seller of the property. When an investor is ready to close on the replacement property of the exchange, the qualified intermediary transfers the funds directly to escrow or the seller of the replacement property or properties. A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property.
Tax and Legal Advice Disclaimer
LFA Multifamily does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on, for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction.