Aug 10, 2023
Petna Jenner
A 1031 exchange is a way to sell an investment property and use the money to buy another property without immediately paying taxes on the profit you made from the sale. You can trade one property for another in a set time period without the tax bill.
What qualifies for a 1031 or like-kind exchange
Typically, investment properties like rental homes, commercial buildings, and vacant land are eligible for this tax-saving strategy. However, primary residences and properties bought primarily for personal use do not qualify.
Types of qualifying property
It's important to remember that the properties involved must be held for business or investment purposes.
Single-family homes that are rented
Multi-family buildings
Vacant land
Commercial buildings
The 1031 exchange timeline — it’s quick!
The 1031 exchange timeline consists of two main deadlines.
Identification Period (45 days): After selling your original investment property, you have 45 calendar days to identify potential replacement properties. During this period, you must provide a written list of the properties you intend to acquire. You can identify up to three properties without regard to their value, or you can identify more than three properties with a combined value that does not exceed 200% of the value of the property you sold.
Exchange Period (180 days): After the identification period, you have a total of 180 calendar days from the sale of your original property to complete the purchase of one or more replacement properties. This 180-day period includes the initial 45-day identification period.
It's crucial to adhere to these timelines to complete a 1031 exchange and defer capital gains taxes on the sale of your investment property.
What doesn’t qualify for a 1031 exchange?
Properties that do not qualify for a 1031 exchange typically include:
Primary Residences: Your main home where you live most of the time does not qualify.
Vacation Homes: Properties primarily used for personal enjoyment and not for investment or business purposes.
Property Flips: Properties bought to quickly sell for a profit rather than hold for investment.
Dealer Properties: Properties held primarily for resale in the ordinary course of business, such as those owned by real estate developers.
Inventory or Supplies: Real estate used as inventory in a trade or business, like properties held by a retailer.
Partnership Interests: Shares in a partnership, unless specifically structured as a 1031 exchange of partnership interests.
Stocks, Bonds, and Notes: These are considered financial assets rather than real property.
Foreign Properties: Properties located outside of the United States.
Personal Property: Furnishings, equipment, and other movable assets not considered real estate.
Calculating your tax deferral and potential taxes owed
In a 1031 exchange, the amount an investor can buy a replacement property for is determined by the equity from the relinquished property and any additional funds the investor might decide to invest.
Here's how the calculation generally works:
Equity from Relinquished Property: The first step is to determine the net equity from the property you're selling (relinquished property). This is calculated by subtracting the outstanding mortgage balance, selling costs (such as real estate agent commissions and closing costs), and any other liabilities associated with the sale from the sale price.
Net Equity = Sale Price - Mortgage Balance - Selling Costs - Liabilities
Identification of Replacement Property: During the 45-day identification period, you can identify potential replacement properties. You can choose one or more properties as long as their total value doesn't exceed 200% of the net equity from the relinquished property.
It's important to note that the goal of a 1031 exchange is to defer capital gains taxes, so the total amount you invest in the replacement property should ideally be equal to or greater than the net equity from the relinquished property to fully defer taxes on the gain.
Working with a Qualified Intermediary to run your exchange
Working with a qualified intermediary (QI) is crucial in a 1031 exchange. Here's how the process generally works:
Engage a Qualified Intermediary: Once you've decided to pursue a 1031 exchange, you'll need engage a qualified intermediary. A QI is a third-party facilitator who helps manage the exchange process and ensures compliance with IRS regulations.
Initiate the Exchange: Before closing the sale of your relinquished property, you'll need to include a provision in the sales contract indicating your intention to perform a 1031 exchange and the involvement of a QI. The contract will specify that the net proceeds from the sale will be transferred directly to the QI.
Notify the QI: Once the sale of your relinquished property closes, you'll notify the QI of the sale and provide them with the necessary details, such as the sale price, property description, and closing date.
45-Day Identification Period: Within 45 days of the sale closing, you must identify potential replacement properties to the QI in writing. The QI will help you prepare the identification notice and ensure it meets IRS requirements.
180-Day Exchange Period: After identifying the replacement property, you have 180 days from the sale closing to complete the purchase of the replacement property. The QI will coordinate the funds transfer for the purchase.
Purchase of Replacement Property: The QI will work with the closing of the replacement property, ensuring that the funds from the relinquished property are used to acquire the replacement property directly.
Reporting and Documentation: Throughout the process, the QI will handle necessary documentation, such as preparing exchange agreements and ensuring all required paperwork is completed and submitted to the IRS.
Completion of Exchange: Once the purchase of the replacement property is finalized, the QI will ensure that the transaction is structured as a valid 1031 exchange, providing you with the necessary documentation for tax reporting.
Want more? Here is a helpful 4-page read from the IRS.