If you want to play the game, you have to know the rules
So now you are ready to sell your property and buy another in order to take advantage of a 1031 Exchange and continue to grow and preserve your wealth. There are quite a few rules laid down by the IRS in order to complete a successful exchange and get a full tax deferral, which I will outline for you below. Prior to going over them, I encourage you to think about a 1031 Exchange like a game. There are certain rules to abide by, timelines, and multiple ways to win as well as multiple ways to not come in dead last. Remember that the worst that can happen is that if you completely fail an exchange, you end up paying the taxes that were due on the sale of your property anyway.
We’ve already covered the 3 requirements to qualify for a 1031 Exchange, but let’s sum them up with the 3 T’s; Title, Taxes, and Time. You must have owned the property as the same entity and reported income taxes under that entity for that property for at least 2 years.
There are exceptions to this basic qualifier, and you should consult your tax or legal professional if you believe you fall under one of the possible exceptions and still want to perform a 1031 Exchange. I use this as a general rule from Qualified Intermediary perspective, meaning; there have been no issues from the IRS in our experience when these simple criteria are met and allows us to accommodate your exchange with confidence
Ways to play the game: Different types of Exchanges
All the following methods for performing a 1031 Exchange require a Qualified Intermediary, Assignment Agreement, and/or Exchange Accommodating Titleholder. If these pieces are not in place prior to closing on a property you’ve elected not to play the game. You cannot choose to perform a 1031 Exchange if the proceeds from the sale do not pass directly to the Q.I. upon close. Make sure to contact your Exchange Accommodator in order to set up your Exchange before closing on your property.
Also called a Delayed Exchange; it is the most commonly performed 1031 Exchange method and the easiest because it doesn’t require an Exchange Accommodating Titleholder. In this method, the Exchanger sells a property, called the relinquished property, and then uses those sale proceeds to purchase a replacement property or properties. The closing date of the relinquished property is the Exchange start date for the 45/180-day rule.
This type of Exchange allows the Exchanger to purchase a replacement property before selling their relinquished property by using an Exchange Accommodating Titleholder. This is done by the Exchanger setting up and assigning the property to the EAT prior to closing. The Exchanger then has 180 days to sell their relinquish-able property or properties and place the proceeds into the replacement property held by the EAT. When the sales are finalized, the Exchange Accommodating Titleholder then transfers title back to the Exchanger and the Reverse Exchange is complete. This method is a much more complicated process and costs more to set up but can give an Exchanger an upper hand when consolidating multiple properties into one. Please consult with your Exchange Accommodator before performing a Reverse Exchange as additional entities and compliance rules are required prior to exchanging.
Also known as a Construction Exchange or Improvement Exchange. While called by several names, in essence this allows the Exchanger to purchase a property or land and make improvements to that property using Exchange funds. Setting up an Exchange Accommodating Titleholder is required to hold the property while improvements are being made. All improvements, inspections, and transfer of title must be made within the 180-day allotment for the Exchanger to successfully perform this type of 1031 Exchange. Again, due to the complexity of this method, please consult with your Exchange Accommodator before attempting to perform this type of Exchange.
Rules of the Game: Timeline Rules
45/180 Day Rule
This is the Timeline rule for a 1031 Exchange and both the 45 and 180 days are in reference to the closing date of the first property.
45 days is allowed for an Exchanger to Identify a property or properties that they wish to purchase with their exchange funds. This Identification process is as simple as writing down a property address or APN and percentage of interest or dollar amount in consideration for purchase. You do not need to be under contract with any of these properties in order to Identify them, nor does getting under contract on a property the same as identifying it. If the Exchanger wants to sell more than one property and put those proceeds into the same Exchange, this 45-day period is also the same amount of time they have to sell those other properties and conjoin it to the same Exchange.
180 days refers to the entire time to perform a 1031 Exchange, it also starts on the day of closing your first property, and applies to all Exchange methods; forward, reverse, and build-to-suite. In a Forward Exchange, this means that on the 45th day when you’ve finalized the identification of your properties, you have a remaining 135 days to finish closing on the identified property or properties.
Rules of the Game: Identification Rules
3 Property Rule
Every forward exchange allows the Exchanger to identify up to 3 properties with no further rules coming into play. They may exchange all or part of their proceeds into one, two, or all of them.
Identifying more than 3 properties is possible but then the 200 and 95 rules come into play.
Identifying 4 or More Properties
When using the 200% rule, the Exchanger is allowed to identify as many replacement properties as they wish, however, the total value of all replacement properties does not exceed 200% of the relinquished property’s value.
The is allowed to identify more than 200% of their relinquished value, but then must abide by the 95% rule. When using the 95% rule the Exchanger is allowed to identify any amount of replacement properties so long as they replace and receive at least 95% of the value of all the identified properties.
Those are the rules for identification and there’s some strategy to employ when identifying that can help guarantee success. We will talk about those strategies in another article. For now, let’s talk about winning.
Winning: Full or even Partial Tax Deferment
In order for an Exchanger to fully defer their Depreciation Recapture, Medicare, Federal, and State Capital Gains taxes, they must follow all of the exchange guidelines.
All proceeds from the sale of a property must pass directly to the Qualified Intermediary. Any proceeds passing into the hands of the seller and not the QI will not be eligible for a 1031 Exchange and will be liable for taxes.
All time guidelines must be followed in accordance with the IRS Tax Code Section 1031.
The purchase price of the replacement property or properties must be greater than or equal to the value of the relinquished property, otherwise the exchanger will incur “Boot”.
100% of the exchange funds must also be used towards the replacement property in order to be fully deferred, otherwise the exchanger will incur “Boot”.
“Boot” is simply remaining debt or equity left unaccounted for in an exchange. “Boot” is liable for taxes. It is not advisable to have more “Boot” than there was appreciation and depreciation on the property as the taxes incurred will negate the savings from performing an exchange.
Following these rules is all you need to do to win, the only way to lose is by not following the rules or not completing your exchange, in which case you’ll just end up paying the taxes that were due on sale anyway. I realize that following these rules, especially the timelines, seem difficult, and this is why it's vital to choose the right Exchange Accommodator. Like any game you play, having a good coach is essential. Someone to walk you through the entire process, be mindful of the rules, and help you adhere to the deadline dates. This is where I come in, not only do I act as the Qualified Intermediary necessary to your exchange, I also walk with you from beginning to end, and I love to WIN.
If you have any additional questions regarding these rules, I’m happy to help answer them. Don’t miss part 3 in our 1031 series where you will learn some strategies on exchanging successfully.