Exchange Basics

A 1031 exchange allows an investor or business owner to sell a piece of property and use the proceeds to buy another piece of property later on. As long as it's done following the IRC Section 1031 rules and using the services of a qualified intermediary, the investor or business owner can defer any taxes he/she would have had to pay on the property they sold.

There are three main rules that must be followed in order to qualify for a 1031 exchange. They are:

  1. The properties exchanged must qualify as "like-kind."
  2. There must be an actual exchange, not just a transfer of property for money.
  3. The time requirements must be strictly followed.

The first rule specifically states that the properties must be "like-kind." This refers to the same type of property, not its grade or quality. As long as the property was held for investment or productive use in a trade or business, real property can be exchanged for other real property and personal property can be exchanged for other personal property. Real property is considered land, buildings, and all the things that are attached to the land, such as a house, trees, or even light fixtures and plumbing. Personal property is considered anything that is not nailed down, dug into, or built onto the land, such as office furniture, cars, livestock, or even copyrights and patents.

The second rule specifically states that an actual exchange must occur. In order for this to happen, the exchanger cannot touch the money from the sale of their property. It will not qualify as an exchange if you simply sell your property and then reinvest the money in another property. The money must pass through a qualified independent third party in order to meet the requirements imposed by the IRS for a valid 1031 exchange. The exchanger is not allowed to have access to the sale proceeds of the relinquished property.

The third rule imposes time requirements on the whole exchange.

The two time limitations are:

  1. The 45-day identification period; and
  2. The 180-day exchange period

The 45-day identification period begins on the date you close on the relinquished property (the property you sold) and ends 45 days later. To defer all of the capital gains, an investor or business owner must acquire property of equal or greater value than the property sold, and must reinvest all proceeds from the property sold. Receiving cash, or trading down in value, is treated as boot and taxed as capital gain. Proper identification of the replacement properties must be in writing, signed by the exchanger, and either hand delivered, mailed, faxed, or e-mailed to the qualified intermediary on or before midnight of the 45th day following the initial closing. Replacement property is identified only if it is unambiguously described, such as by its legal descriptions or street address. If a "like-kind" replacement property has not been properly identified to the intermediary, the exchange will not work and the investor or business owner will be unable to defer the capital gains.

You may identify more than one property as replacement properties subject to two rules:

  1. 3-property rule: An exchanger may identify up to three properties regardless of their fair market value. The exchanger is not obligated to purchase all three properties but must purchase at least one of the three identified properties.
  2. 200 percent rule: An exchanger may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all relinquished properties.

If, as of the end of the identification period, you have identified more properties as replacement properties than permitted, it is treated as if no replacement properties have been identified. This will not apply, with respect to:

  1. Any replacement property received by the exchanger before the end of the identification period; and
  2. Any replacement property identified before the end of the 45-day period and received within the 180-day period, as long as the exchanger acquires enough identified properties with a fair market value of at least 95 percent of the total fair market value of all the identified replacement properties (95 percent rule).

EXAMPLE: A taxpayer transfers relinquished property with a fair market value of $1 million and identifies four replacement properties with fair market values of $1 million, $1 million, $900,000, and $100,000, respectively, for a total of $3 million. The taxpayer acquires the first three replacement properties with aggregate fair market values of $2,900,000 but does not acquire the fourth replacement property. Because more than three properties were identified, the taxpayer does not satisfy the 3-property rule. Because the aggregate fair market value of the four identified replacement properties is 300 percent of the fair market value of the relinquished property, the taxpayer does not satisfy the 200 percent rule. The 95 percent rule is satisfied, however, because the taxpayer received at least 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period ($2,900,000 divided by $3,000,000 = 96.67 percent).

The 180-day exchange period begins on the date you transfer the relinquished property and ends on the earlier of 180 days after or on the due date (including extensions) of your tax return for the taxable year in which the transfer of the relinquished property occurred. The exchange is considered to be complete as long as the exchanger closes on the replacement property within this 180-day period.

The qualified intermediary is a person (or company) who, for a fee, acts to facilitate the 1031 exchange by entering into an agreement with the investor or business owner for the exchange of properties. The role of the qualified intermediary is to act as a middleman in both the sale and purchase transaction. An exchanger must use a qualified intermediary. The qualified intermediary cannot be the exchanger or an agent of the exchanger, such as their realtor, attorney, tax advisor, banker, accountant, employee, or mortgage lender, within a 2-year period ending on the date of the transfer of the first relinquished properties.

The qualified intermediary does not provide legal or tax advice to the exchanger, but will perform the following services:

  1. Coordinate with the exchanger and their advisors to structure a successful exchange.
  2. Prepare the appropriate documentation for the 1031 exchange.
  3. Furnish escrow with instructions to effect the exchange.
  4. Secure the funds in an insured bank account until the exchange is completed.
  5. Provide the documents to transfer the replacement property to the exchanger and disburse the exchange proceeds to escrow.

For more information, please contact 1031 Accommodators®, LLC.

For further reading:
- 1031 Exchange Basics
- 1031 Frequently Asked Questions
- Exit Strategies and Tax Planning of Mixed and "Dual" Use Properties.
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