What Is a 1031 Exchange?

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November 2, 2022

Two-story white brick residential house

Taxes are typically unavoidable fees in any financial transaction. However, in the real estate world, there are few avenues through which investors can avoid paying these taxes. One such avenue is the 1031 exchange. So, what is a 1031 exchange, and how does it work in real estate?

What Is a 1031 Exchange?

A 1031 tax-deferred exchange is a term used to describe section 1031 of the Internal Revenue Code that allows real estate investors to defer capital gains tax while selling one property for another.

This exchange allows investors to defer up to $250,000 in capital gains tax for single individuals and $500,000 for married couples filing jointly. If properly done, there is also no limit to the number of times an investor can use this avenue to defer capital gain taxes on commercial properties

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What Are the Rules Guiding 1031 Exchanges?

If you are considering a 1031 exchange, it is important to know that certain rules guide the execution of a 1031 exchange. These rules must be properly understood before venturing into a tax-deferred exchange. 

Like-Kind Property 

This is perhaps the most important rule guiding the 1031 exchange, which states that before you can trade one property for another, it must be similar to the replacement property in question. This means they must have similar characteristics, such as: 

  • They must be situated in the United States 
  • They must be held for the same purpose -which should be strictly commercial, not residential 
  • They must have an equivalent market value

For example, you cannot exchange a personal use property such as a vacation home for commercial property. Also, you can not exchange a property outside the United States for a property in the United States.

The 45-Day Rule

This rule states that the exchanger must identify a maximum of three like-kind replacement properties within 45 calendar days following the closing of the sale of the relinquished property. You must carry out this identification in writing and send it to the intermediary as proof of adherence to the rule.

The 180-Day Rule

This rule states that a taxpayer has 180 days to finalize and close the purchase of the replacement property to qualify for tax deferment. Many investors misinterpret this timeline to mean that one has 180 days from selling the relinquished property to round up the transaction.

However, this is not the case, as the taxpayer has only 180 days to sell the relinquished property and acquire the replacement property. Therefore, if the relinquished property was sold on day 10 of the transaction and the replacement property was identified on day 53, only 127 days remain for the entire 1031 exchange to be finalized.

The 3-Property Rule

The 3-property rule states that an investor can identify three same-kind replacement properties of any value, provided at least one of the properties are purchased. With the 3-property rule, the investor does not have to consider the market price of the identified properties compared to that of the relinquished property.

The 200% Rule

This rule states that as a taxpayer, you can identify an unlimited number of properties, provided the collective market value of the replacement properties in a 1031 exchange does not exceed 200% of the market value of the relinquished property. 

This simply means that the total price of the identified properties should not exceed double the market value of the relinquished property. For example, if an investor relinquishes a property worth $1 million and is looking to identify replacement properties, the total value of all the properties identified should not exceed $2 million.

The 95% Rule

The 95% rule in real estate states that a taxpayer can identify any number of properties, regardless of their values, so long as the taxpayer closes on at least 95% of the total value of the identified properties.

Light yellow miniature wooden house with four rows of coins stacked behind it

This rule gives taxpayers more room to identify properties than the other rules as long as they have the financial capacity to acquire 95% of the current aggregate value of the identified properties.

How to Conduct a 1031 Exchange in Northern Kentucky 

Having understood what a 1031 exchange entails and decided on it, it is important to understand what steps are involved in achieving a successful 1031 exchange in Northern Kentucky. The steps include:

Hiring an Agent

A 1031 exchange is worth it but can be extremely dicey, and one wrong move could ruin the entire transaction. This is why for real estate investors, both beginners and experts, it is advisable to hire a real estate agent to guide them through any difficulties that may arise during the exchange.

A qualified agency, such as Si Vales Valeo Real Estate, will assist you in gathering the necessary documents required during the exchange while offering valuable guidance and strategies to help you maximize the benefits of a 1031 exchange.

Individual Ownership of Property 

It is easier to carry out a 1031 exchange on a single-owner property than on a property owned by many individuals or on a property with a disputable title. This is because, unlike the latter, the former poses no risk of conflicting interests arising between the owners that could complicate or impede the exchange process. 

Therefore, before deciding to begin a 1031 exchange, ensure to carry out a title search to rule out disputes in the title and tax payments of the properties to be exchanged. This enables you to avoid any difficulties or possible disqualification of your property from the selection criteria. 

Choosing an Eligible Intermediary 

The next step is choosing an intermediary. The right intermediary should be a neutral party independent of the other parties involved in the transaction. This intermediary could be an individual or a company.

The intermediary signs a written agreement with the exchanger, giving the intermediary the authority to perform their duties. These duties include holding the proceeds from the sale of the relinquished property in an escrow account and releasing the funds to the owner of the replacement property. 

Once the payment is released to the seller of the replacement property, the transaction can be sealed. Your choice of an intermediary is very crucial to the success of the exchange; hence, it is crucial to work with an approved and high-quality intermediary who would protect your interest. 

Selling the Relinquished Property 

Once a qualified intermediary has been selected, the taxpayer looks for a suitable buyer for relinquishing the property. As soon as a buyer is identified, both parties sign a written agreement, after which the funds and property are transferred to the intermediary. 

The intermediary then proceeds to hand over the deeds of the relinquished property to the buyer while holding the funds from the sale of the relinquished property. 

Identifying the Replacement Property 

Following the relinquished property sale, the taxpayer proceeds to identify the replacement property, using any of the rules guiding the exchange process, including the 3-property rule, the 200% rule, and the 95% rule. Within the 45-day identification period, the taxpayer can alter the choice of replacement properties as often as they choose. 

Two-story white brick residential house

For a property to be identified according to IRS requirements, it must be done in writing and duly signed. The identification document must also contain a detailed legal description of the property, after which it is submitted to the qualified intermediary in person or via mail.

Acquiring the Replacement Property 

Once the replacement property has been duly identified, the intermediary then proceeds to transfer the funds from the sale of the relinquished property on behalf of the taxpayer to the seller for the purchase of the replacement property.

This process must be completed within 180 days to be regarded as a 1031 exchange and qualify for tax deferment. 

What Properties Qualify for a 1031 Exchange?

Before putting up a property for a 1031 exchange, it is necessary to determine if such properties qualify for tax deferment. According to the Internal Revenue Service, here is a list of properties that qualify for a 1031 exchange:

  • Residential, commercial, industrial, or retail rental properties 
  • Raw land or farmland for improved real estate
  • Oil & gas royalties for a ranch property
  • Mitigation credits for restoring wetlands for other mitigation credits
  • Simple interest fees in real estate, for example, a 30-year leasehold or a Tenant-in-Common interest in real estate
  • Rental ski condo for a three-unit apartment building.

The following properties do not qualify for a 1031 exchange:

  • Stocks in trade or any other property held primarily for sale, i.e., property held by a developer
  • Securities or other evidence of indebtedness or interest
  • Foreign real property for U.S. real property
  • Stocks, bonds, or notes
  • Certificates of trust or beneficial interests
  • Interests in a partnership
  • Goodwill of businesses
  • Rights to receive money or other property by judicial proceeding
  • A second home or vacation home held strictly for personal use with no rental activity.

Related Questions

Can You Do 1031 With a Family Member?

Yes, you can carry out a 1031 exchange with a family member, provided they have held the replacement property for up to 2 years. Also, both parties must adhere to the specific rules in Section 1031 guiding such transactions to avoid disqualification and revoking the tax deferment

How Long Must You Live in a Property to Avoid Capital Gains?

According to IRS section 1031, an investor must have held a property for at least 5 years and lived in it as the principal residence for at least two years out of the 5 years for the property to qualify for a capital gain tax deferment.

Conclusion

The 1031 exchange is a means by which investors make profits, diversify their investments portfolio and delay the payment of capital gains tax. This article provides information that will guide investors in understanding what a 1031 exchange entails, how to qualify for it, and make the best of this opportunity.

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