1031 Exchange Rules
If you own an investment property, you may want to understand the set of IRS rules for 1031 real estate exchanges. You may need to pay a significant capital gains tax if you make more off selling an investment property than you paid for it, so it’s important to understand how 1031 exchanges work and the rules in order to make the best decisions for your investment property.
A 1031 exchange can be a great tax advantage for real estate investors, allowing you to defer paying taxes on your investment property’s sale for virtually as long as you want. This 1031 exchange overview guide will help you through the process.
During a 1031 exchange, there are several rules to follow. After you sell your property and do a 1031 exchange, the money will be held in escrow. This is an independent account that a third-party monitors. To have a successful exchange, you will not be able to access this money. When you are ready to close on your replacement property, the intermediary will use the funds to purchase the property on your behalf.
Keep in mind that you cannot use money from a 1031 exchange for anything other than purchasing a new property. If you don’t roll your money into another investment, you’ll have to pay capital gains taxes on the sale. In essence, you are exchanging one investment for another without cashing out.
Like-Kind Properties Rule
A 1031 exchange needs to be completed with like-kind properties. The like-kind property definition is not too restrictive. For example, you can sell a rental house and then purchase a small apartment building rather than needing to exchange a house for a house or a two-story building for a two-story building.
Additionally, the properties do not need to be part of the same sector. For instance, if you sell an industrial building, you can use the proceeds to purchase an apartment building. While international properties are not considered eligible like-kind 1031 exchange properties, you can conduct a 1031 exchange with almost any property in the U.S.
Three Property Rule
In a 1031 exchange, you can identify as many as three possible properties to purchase, as long as you buy at least one of these properties. The federal government sets this limit of three properties. Many real estate investors limit their options to three properties to minimize paperwork and avoid becoming subject to more complicated tests.
Under the 200% rule, you can identify however many replacement properties you wish to purchase, as long as the properties’ combined fair market value does not equal more than 200% of the property you relinquished. For example, if you sell a property for $200,000, then the combined fair market value of your purchase should not exceed twice that amount, or $400,000.
Under the 95% rule, you can choose to ignore the 200% rule and find whatever number of possible replacement properties you choose, for any amount, as long as you purchase 95% of these properties’ aggregate value. For example, if you sell a property for $250,000, you can identify five properties with a total worth of $290,000. However, you would need to purchase at least 95% of these properties’ value, or $275,500.
Investment Property Rule
A personal residence cannot be traded in a 1031 exchange. This means you cannot sell your personal residence, and you may not be able to sell a vacation home or second home either. If you lived in the home for the past few years, you likely will not be able to exchange it.
Additionally, a fix and flip property does not count as a 1031 exchange property either. For properties to be used in a 1031 exchange, the old and new properties need to have been used in a business or a trade or held as an investment.
In a delayed 1031 exchange, you need to observe the 45-day rule. When you sell your property, your intermediary will receive the money. Within 45 days of your property’s sale, you should designate your replacement property to your intermediary in writing, stating which property you would like to acquire.
Again, you need to follow the three property rule, the 200% rule or the 95% rule when designating properties.
Finally, for a delayed 1031 exchange, another rule is that you should close on your new property within 180 days after you sell your old property. Alternatively, the replacement property should be received by the tax return’s due date, including extensions.
Whichever timeframe is earlier is the one that is applicable to your situation. So if the 180-day rule is earlier than the due date of your tax return, then you will need to close on your new property in that 180-day period.
1031 Exchange Rule Updates for 2022
There have been some changes in the 1031 exchange rules to consider in 2022. The IRS issued final regulations on the definition of “real property.” In a 1031 exchange, a property is considered real property if it is defined as such under local or state jurisdiction where it is located on the date of the transfer.
As a result of the Tax Cuts and Jobs Act, the IRS published proposed regulations to address which assets are eligible for a 1031 exchange. Previously, personal property could sometimes be exchanged in a 1031 exchange, such as aircraft, equipment and franchise licenses. However, this is no longer the case. According to the new rules, only real estate properties qualify for 1031 exchanges.
A transition rule was put in place to permit a 1031 exchange if the replacement property was acquired or the original property was sold by December 31, 2017. Exchanges of partnership interests or corporate stock do not qualify for a 1031 exchange, but interests in a tenant-in-common (TIC) or a Delaware Statutory Trust (DST) arrangement in real estate do.
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