1031 Exchange Rules | Above & Below 1031

1031 Exchange Rules and Qualifications

Real estate investors may benefit from doing a 1031 exchange because it helps them to defer taxes on capital gains and depreciation recapture by reinvesting their proceeds in the purchase of like-kind real property. Since IRC Section 1031 is a tax code, the IRS imposes strict rules and regulations that must be followed to complete a successful 1031 exchange. Below is a list (although not thoroughly exhaustive) of the main rules to know when opening a 1031 exchange. Please contact us to discuss your situation and goals to determine whether you qualify to do a 1031 exchange and if it is the right solution for you.

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1031 Exchange Requirements

Exchange Agreement with a Qualified Intermediary:

To successfully complete a 1031 exchange, you must have an Exchange Agreement in place with a Qualified Intermediary before you close on the sale of your (first) relinquished property. If the closing has already taken place, it is too late to do an exchange, even if you have not personally received the funds yet.

Do Not Receive Cash:

One of the main roles of the Qualified Intermediary is to hold the proceeds from the sale of the relinquished property in an escrow account during the exchange. If you take constructive receipt (have control over) or take receipt of the funds in any way, you will likely disqualify the exchange completely.

Receive Like-Kind Real Property:

The IRS requires that the replacement property must be real property that is like-kind to the relinquished property that was sold. Examples of real property are single- and multi-family properties, commercial real estate (office, retail, etc.) bare and agricultural land, oil & gas mineral rights, Delaware Statutory Trusts (DSTs), etc. These types of properties are all considered like-kind to each other so they can be exchanged for one another. On the other hand, interest in a partnership, securities, collectibles, etc. are not considered real like-kind property.

Use and Holding Period:

To qualify for a 1031 exchange, both the relinquished and replacement properties must be held for investment or productive use in a trade or business for a period of time. Properties held as inventory (fix-n-flips, for example), personal residences, second homes, and personal property do not qualify for 1031 exchanges. The IRS has not defined a specific amount of time, but generally 2 years or more is pretty safe. If held for less time, the facts and circumstances surrounding the intended use when purchasing the property and being able to demonstrate that intent comes into play. Exchanging or selling properties held for less than a year may cause a red flag and could result in challenges from the IRS.

Same Taxpayer Rule:

The legal entity or individual(s) who purchase the replacement property must be the same legal entity or individuals who sell the relinquished property. There are many different situations that could arise when it comes to qualifying for an exchange under this rule. Contact us to discuss your scenario and goals to see if it will qualify.

Taxable Boot:

Any funds that you retain from the sale of the relinquished are taxable (and referred to as “boot”). They are not considered a return of your investment (cost basis). If you receive cash or property that is not like-kind real property when purchasing replacement property, it is also taxable boot. Any funds that are not used to buy replacement property are taxable.

Report the Exchange:

When filing your taxes for the year that the relinquished property was sold, you/your tax preparer must complete Form 8824 and include it with your tax return. As stated above, all replacement property must be purchased before filing the tax return, so an extension may be needed to allow for additional time.

Learn more about the process to do a 1031 exchange.

45-Day Identification Deadline:

The IRS requires you to identify potential replacement property(ies) by midnight of the 45th day from the date you close on your (first) relinquished property. Once the deadline has passed, the letter cannot be changed. You can only purchase property that is listed on the identification letter. Additional rules for submitting the identification letter apply.
When identifying potential replacement properties, you must follow one of these 3 rules regarding the number and value of the properties being identified:

The 3-Property Rule – Most Commonly Used:

The 3 property rule states that you may identify up to 3 properties of any value, and then you can purchase anyone, two, or three of them.

200% Rule:

The 200% rule states that you may identify 4 or more properties so long as their combined value does not exceed 200% of the value of the relinquished property. You can purchase any number of them.

95% Rule:

The 95% rule states that you may identify 4 or more properties of any value so long as you actually purchase at least 95% of the total value of all the properties that were identified.

180-Day Deadline:

From the date of sale of the (first) relinquished property, you have a total of 180 days or by your tax return deadline (including extensions), whichever comes first, to purchase property that was identified on the ID letter. If you opened an exchange in the previous year, are still within your 180 days, and have yet to purchase all replacement properties, you should not file your tax return for the previous year until all properties have been purchased. An extension should be filed in this case.

Exchange Up

For full tax deferral, you always want to “exchange up”. There are three criteria that must be reached to accomplish this; any difference is considered taxable boot.

Purchase Price:

The value of the replacement property(ies) must be equal to or greater than the value of the relinquished property(ies), less closing costs.

Debt Off-Set:

You must acquire the same or greater amount of debt on the replacement property as what was paid off or assumed by the buyer of the relinquished property. This can be accomplished with a loan and/or by bringing cash to the table.

All Sales Proceeds:

All proceeds from the sale of the relinquished property must go into the exchange account and then all funds must be used towards the purchase of the replacement property for full tax deferral.

Multi-Property Exchanges:

You can sell more than one relinquished property and/or purchase more than one replacement property. This is a great strategy to reduce or expand the size of your portfolio and diversify into different types of like-kind assets. The cumulative amount for all properties on either side of the exchange needs to be taken into consideration when calculating the “exchanging up” numbers.
The clock for the 45- and 180-day deadlines starts with the closing date of the first relinquished property. To avoid a more complicated and costly reverse exchange, you’ll want to make sure that all of the relinquished properties close before any of the replacement properties and that all replacement properties are purchased by the 180th day.

There's More to Know

These are the main rules and qualification requirements to complete a 1031 exchange, but it is not exhaustive. Schedule a call to discuss your unique situation, needs, and goals to see if a 1031 exchange is feasible for you.