A 1031 exchange can offer flexibility in how you reinvest in real estate, but the IRS rules are specific. Missing a deadline or taking control of exchange proceeds may cause some or all of the gain to become taxable. Aspen Exchange helps coordinate the exchange process, documentation, deadlines, and funds.
Section 1031 is designed to let eligible investors defer recognition of gain when they exchange real property held for business or investment for like-kind real property. The rules generally address two things: when the exchange must happen and whether the taxpayer received cash or other property as part of the transaction.
How Deferred Exchanges Work
Early exchanges usually involved owners swapping properties at the same time. Today, many investors use a deferred exchange: they sell their relinquished property first, then acquire replacement property within the applicable deadlines.
A qualified intermediary can facilitate this process. For a typical deferred exchange, the intermediary works under a written exchange agreement and helps prevent the taxpayer from taking actual or constructive receipt of the sale proceeds. Engage your qualified intermediary before the sale closes. Internal Revenue Service
7 Key Rules for a 1031 Exchange
- Set up the exchange before the sale closes
- Exchange qualifying property for like-kind property
- Follow the value and reinvestment requirements
- Understand when cash or other “boot” may be taxable
- Keep the taxpayer consistent through the exchange
- Identify replacement property within 45 days
- Complete the exchange within the applicable exchange period
Download the free guide: 1031 Exchange Basics
1. Set Up the Exchange Before the Sale Closes
The exchange must be arranged before the relinquished property sale closes. If you receive or control the proceeds from the sale, the transaction may not qualify for deferred exchange treatment.
A qualified intermediary, sometimes called an exchange accommodator, helps structure the transaction under a written exchange agreement. After the sale, the intermediary holds the exchange funds and coordinates their use toward the purchase of replacement property.
You must also send your replacement property identification to the qualified intermediary or another permitted recipient by the identification deadline. Aspen Exchange can help coordinate the required documents and deadlines.
2. Exchange Qualifying Property for Like-Kind Property
Both the relinquished property and the replacement property must generally be real property held for investment or productive use in a trade or business. “Like-kind” refers to the nature or character of the real estate, not necessarily its property type. For example, qualifying investment real estate may be exchanged for a different type of qualifying investment real estate.
Property held primarily for personal use generally does not qualify. Property held primarily for resale, such as dealer inventory, generally does not qualify either. Whether a property qualifies depends on the facts, so discuss your situation with your tax advisor.
An exchange may involve multiple relinquished properties, multiple replacement properties, or a combination of both, subject to the identification rules and other requirements.
3. Follow the Value and Reinvestment Requirements
Investors seeking to defer all gain generally need to acquire replacement property with a value equal to or greater than the relinquished property and reinvest all net exchange proceeds. Debt paid off as part of the sale may also affect the exchange. If the replacement property involves less debt, additional cash may be needed to avoid taxable gain, depending on the transaction.
For example, if a property sells for $1,000,000 and allowable selling expenses total $50,000, the net sale value for this simplified example is $950,000. A loan payoff does not automatically reduce the value of the relinquished property for exchange purposes.
The actual calculation depends on transaction details, including selling expenses, debt, cash contributed, and any non-like-kind property received. Have your tax advisor evaluate the numbers for your exchange.
4. Understand When Cash or Other “Boot” May Be Taxable
“Boot” is the term often used for cash or other non-like-kind property received in an exchange. Depending on the transaction, boot may include cash retained from the sale or a reduction in debt that is not offset by replacement debt or additional cash.
Receiving boot does not automatically disqualify the entire exchange, but it may result in taxable gain. The amount and character of any tax depend on your circumstances. Aspen Exchange coordinates the exchange process; consult your CPA or tax attorney about potential tax consequences.
5. Keep the Taxpayer Consistent Through the Exchange
In general, the taxpayer that transfers the relinquished property should be the taxpayer that acquires the replacement property. A change in the name or entity taking title can affect the exchange.
Ownership structures such as partnerships, multi-member LLCs, and co-ownership arrangements can raise additional questions. Do not restructure ownership or change title for an exchange without first consulting your tax and legal advisors. Aspen Exchange can coordinate with your professional team on the exchange process.
6. Identify Replacement Property Within 45 Days
The identification period begins when the relinquished property is transferred. Replacement property must generally be identified in writing within 45 calendar days.
Identification must describe the property clearly enough to distinguish it. Investors typically include the property address or legal description. If acquiring less than a full interest, such as a fractional interest, include the percentage or interest being acquired.
Common identification methods include:
- Three-property rule: Identify up to three potential replacement properties, regardless of their value.
- 200% rule: Identify any number of properties, provided their combined value does not exceed 200% of the relinquished property’s value.
- 95% rule: Identify any number of properties, but acquire at least 95% of the total value identified.
These rules have specific requirements. Confirm your identification method and paperwork with your qualified intermediary and tax advisor. The IRS generally requires identification within 45 days, and the replacement property must be received within the applicable exchange period. Internal Revenue Service
7. Complete the Exchange Within the Applicable Exchange Period
The replacement property must generally be received by the earlier of:
- 180 days after the transfer of the relinquished property; or
- The due date, including extensions, of your federal tax return for the year the relinquished property was transferred.
The 45-day identification period runs within the overall exchange period. You may acquire replacement property before the 45 days have passed, but the exchange must still meet the identification and receipt requirements.
Because the tax return due date can shorten the available exchange period, speak with your CPA or tax attorney about filing deadlines and extensions. IRS guidance describes both timing limits and applies whichever deadline comes first. Internal Revenue Service
Plan Your Exchange With Aspen Exchange
A successful exchange depends on careful coordination and timely documentation. Aspen Exchange serves as a qualified intermediary and helps investors manage the exchange process from setup through completion.
Speak with an Aspen Exchange advisor.
Call 424-239-7388 or email letstalk@aspen1031.com to discuss your exchange.
