Guide to 1031 Exchanges

Involve a Qualified Intermediary

Once you’ve initiated a delayed 1031 exchange, you must retain a Qualified Intermediary (QI), which is essential to the completion of a successful 1031 exchange. A Qualified Intermediary is a person or company that manages the funds involved after a real estate investor sells their relinquished property and looks for a replacement.

The QI sells your property on your behalf, buys the new replacement property, and then transfers the deed to you. A QI has no stakes in the exchange and holds on to the proceeds from the sale of your property, then transfers the funds to the seller of the replacement property or properties.

The reason for using a QI is for them to act as a third party. It is the responsibility of the Qualified Intermediary to hold the proceeds, prepare the legal documents, and attempt to ensure that the transaction is completed within the IRS guidelines. The QI facilitates delayed exchanges and ensures the funds from the sale are compliant. This enables them to remain nontaxable while the 1031 exchange is completed.

The seller has an identification window of 45 calendar days to identify a like-kind property to complete the exchange. As many as three potential new properties can be identified without regard to cost. No formal filing is required to be made with the IRS. However, it is the responsibility of the Qualified Intermediary to accept the list on behalf of the IRS and document the date it was received.

Once this window closes, and like-kind properties are not identified, the 1031 exchange is considered failed, and funds from the property sale are considered taxable. No extensions are allowed under any circumstances, including holidays.

According to the IRS’s definition of like-kind, “properties are of like-kind if they are of the same nature or character, even if they differ in grade or quality.” Like-kind relates to how the properties will be used. The old property, as well as the new property, must be held for investment or utilized in a trade or business. It is important to note that investors and developers who strictly “flip” or resell properties do not qualify for exchange treatment because their intent is resale rather than investment. This also does not include personal properties, such as the seller’s primary residence.

Due to this slim identification window, investment property owners are strongly encouraged to research and coordinate an exchange before selling their property and initiating the 45-day countdown. Fortunately, investors have multiple identification strategies available, which are summarized in three rules:

1. Three Property Rule: Also known as the Three Property Identification Rule, it enables investors to identify up to three like-kind replacement properties, whatever their fair market values are. After identification, the investor could then acquire one or all of the three identified like-kind replacement properties through the 1031 exchange process. This method is the most popular 1031 exchange strategy for investors, as it allows them to have backups if the purchase of their preferred property falls through.
2. 200% Rule: The 200% Fair Market Value Identification Rule states investors can identify an unlimited number of like-kind replacement properties, provided the total value of all properties at the end of the period doesn’t exceed 200% of the relinquished property’s total net sales value. If an investor wants to perform a 1031 exchange on a property with a sales value of $1 million, they can identify as many replacement properties as desired as long as those properties’ total value doesn’t exceed $2 million. This strategy is often preferred by investors looking to acquire over three investment properties or seeking extra backup properties if a sale falls through.
3. 95% Exception: The 95% Identification Exception states investors can identify an unlimited number of potential replacement properties with an unlimited fair market value, provided the investor acquires and closes on 95% of the identified market value. Using this exception may be an intentional choice if the investor seeks to purchase multiple properties. It may also happen inadvertently from sudden property value increases. Either way, this gets around the 200% rule while still meeting 1031 exchange requirements.

It’s important to note that if the investor fails to identify properties or identifies more properties than allowed by the Three Property Rule or the 200% Rule and cannot apply the 95% Exception, then the 1031 exchange is considered failed.

Once the replacement properties are identified within 45 days of selling the relinquished property, the seller has an additional 135 calendar days to purchase a replacement property to complete the exchange. Investors must purchase a replacement property or properties and have a Qualified Intermediary transfer the held funds within 180 days from the sale of the relinquished property.

This means they have to purchase a replacement property or properties and have the Qualified Intermediary transfer the funds by the 180-day mark. This window may be shorter if the due date of the income tax return for the tax year in which the previous property was sold falls within the 180-day window. In this case, the sale is due by the tax return date. If the deadline passes before the sale is complete, the 1031 exchange is considered failed, and the funds from the property sale are taxable. There are no extensions.

Another point of note is that the individual selling a relinquished property must be the same as the person purchasing the new property. The name must match between the tax returns and titles of the old and new properties for the exchange to qualify for the 1031 rule. The only exception to this rule applies to cases of single-member limited liability companies (SMLLCs).

New and old property titles cannot be in the same name at the same time. If you find an investment opportunity that you must act on before you have sold your current property, someone other than the taxpayer will hold legal title in what is commonly referred to as a qualified parking arrangement. Once the old property is sold, the proceeds will be directed to the temporary titleholder. Then the property may be transferred from the parking arrangement directly to the taxpayer.

The single-member limited liability company may be treated as equivalent to the sole member of the organization. For example, if John Smith is the sole member of J. Smith Investments, LLC, he may sell a property under his name, purchase it under J. Smith Investments, LLC and still qualify under the 1031 code, as they are considered equivalent entities.

When you file your tax return, complete and file IRS Form 8824. This form describes the details of your 1031 exchange, including the:

• Properties involved in the exchange.
• Timeline of the exchange.
• Key parties involved in the exchange.
• Monies and finances involved, including the amount of gain deferred.

1031 exchanges allow investors to defer the capital gains tax, so they can use the entire proceeds from a sale to purchase larger properties instead of paying a portion of those proceeds toward taxes. By minimizing the loss of purchasing power, investors can grow their wealth more quickly and open up more opportunities for investment.

The deferred taxes owed to the IRS after performing 1031 exchanges are erased upon the seller’s death. As long as the seller continuously performs 1031 exchanges to purchase larger properties through their lifetime, they can grow their wealth tax-free and pass it on to their heirs, who will inherit the properties without the deferred taxes.

Long-term capital gains have a maximum tax rate of 20%, with depreciation recaptured at 25%. Because a 1031 exchange allows investors to defer their federal and state taxes on the new investment property, they can use that extra cash towards a wider range of purchasing options. Depending on the property’s price, taxpayers may have access to thousands or hundreds of thousands of dollars to invest in a larger property or potentially receive a higher loan.

With more funds available immediately after the sale, investors can work with their Qualified Intermediary to acquire multiple properties in a single exchange to diversify their portfolios. Investors can also consolidate several properties into one to make property management easier, such as exchanging two duplexes for a retail strip center or one property in a more expensive state for three in a more affordable one.

This flexibility makes managing investment risk more efficient, enables investors to adjust properties based on their desired level of involvement and allows them to take advantage of new opportunities across the U.S.

Investors have the potential to bring in additional income year after year by investing in more valuable and profitable properties through a 1031 exchange. For instance, investors can use the funds from the sale that won’t be taxed to exchange vacant land for a commercial building that generates a steady income and depreciation benefits

1031 exchanges must follow every rule and regulation to the letter or be considered failures. Investment property owners need to know and follow the 1031 guidelines, including what types of properties qualify, how many properties can be identified, what the purchasing guidelines are and more.

Any mistakes can result in a failed exchange. For this reason, it is recommended to work with professionals who are highly familiar with 1031 exchanges to avoid falling outside the rules and harming the exchange’s success. Errors can include:

• Failing to identify enough properties.
• Identifying too many properties.
• Failing to meet the 95% rule.
• Missing crucial identification and exchange deadlines.

If a seller cannot meet the deadlines for the 45-day identification period or the 180-day exchange period, the 1031 exchange is considered a failure. Therefore, the seller will not be able to defer the capital gains tax from selling their property.

This is especially problematic for those who have large capital gains and/or depreciation recapture taxes owed. Upon this failure, sellers have to pay the capital gains taxes for their recent sale and any sale they have performed in the past that utilized the 1031 exchange rule.

One significant issue that investors may encounter is depreciation. Depreciation is the amount of cost on an investment property that is written off each year due to wear and tear. Capital gains taxes are calculated based on a property’s original purchase price plus improvements and minus depreciation.

If an investor sells a property for more than its depreciated value, they have to recapture that depreciation as part of their taxable income from selling the property. If depreciation is not accounted for in subsequent 1031 exchanges, investors may find that their rental incomes fail to keep up with depreciation expenses.

1031 exchange properties are illiquid. While selling is possible, investors would be required to pay taxes. Most real estate investors who own exchange properties used for investment or business purposes, such as renting, should hold their properties for a minimum of two years to prove the intent of use to the IRS and avoid being disqualified from a 1031 exchange for “flipping.”