1031 Exchange Rules – What You Need to Know
April 17, 2017
When you’re thinking about participating in a 1031 Exchange, there are several rules you need to be aware of in order to meet federally mandated guidelines. Below you will find a few of the basic rules to remember.
The primary and most important rule to remember when participating in a 1031 exchange is that taking control of cash or other proceeds before the exchange is complete may disqualify the entire exchange and make all gain immediately taxable. The Federal Government has been very clear that the first way a tax-payer can ruin exchangeability is to take possession or receipt of the proceeds. The funds need to be sent to the qualified intermediary or facilitator upon sale. The QI will provide aid to the exchanger in the execution of the exchange, facilitate the process, hold the proceeds and prepare documentation.
There are many limitations when identifying your replacement property and you must follow the 1031 exchange rules closely. There are several federally mandated steps that must be completed. The first step in a 1031 exchange is known as the Identification Period. This time period begins on the day the exchanger closes on the relinquished property. The exchanger will then have 45 days to identify a potential replacement property. The next time period is known as the Exchange Period. The exchanger will have a total of 180-days from closing on the relinquished property to acquire the replacement property. It is important to remember the first 45-days of the Exchange Period runs concurrently with the Identification Period, meaning the exchanger will only have 135-days from the end of the Identification Period to complete the exchange. There are three ways an exchanger can identify property with their QI using one of the following: the Three Property Rule, the 200% rule or the 95% rule (also known as the 95% exception).
- The Three Property Rule states that exchangers have the ability to identify up to three properties of any size and simply need to close on one or up to all three within the 180-day time period.
- 200% Rule gives the exchanger the ability to identify an infinite number of properties provided the aggregate value of everything identified does not exceed 200% of the value of the relinquished property. For example, if the exchanger sold a property worth $100,000 they could then identify 4, 5 or 6 properties so long as, when added together, the aggregate value of all properties identified does not exceed $200,000.
- The 95% Rule, or the 95% Exception says that should the exchanger exceed the other two identification rules, they must then acquire at least 95% of the cumulative value of all properties identified from all of the properties identified. Failure to do so will cause the exchangeability to end, and the exchanger will be taxed on all gains back to the original cost-basis.
Related post: Identifying Property
Equal or Greater Value
For a 1031 exchange to be “tax deferred,” a taxpayer may not receive excess proceeds from an exchange. The excess proceeds, commonly referred to as “boot,” are fully taxable back to the exchanger’s original cost basis. To follow the rules set out by a 1031 exchange, and to have a fully tax deferred exchange without boot, the exchanger is required to acquire one or more properties of equal or greater value of what they sold. In addition, if the exchanger has debt on the relinquished property they should count on acquiring new debt equal or greater to what was on the previous property.
One of the most important rules to remember when it comes to a 1031 exchange is that personal property is not qualified. In other words, you cannot swap your primary residence for another. Below we have a list of qualified and disqualified properties.
The following are examples of qualified exchange properties 1031 consideration:
- Raw or vacant land
- Commercial properties
- Rental properties
- Farm land
- Retail properties
- Industrial properties
- Leasehold interest of 30 years or more
- Delaware Statutory Trusts (footnote)
- Working interest in oil and gas
What are disqualified properties?
- Primary Residence
- Second Home
- Stock in trade or inventory
- Property specifically held for resale/speculation
- Vacation homes (most)
- Partnership interests
- Securities or other evidences of indebtedness
Related Post: Like-Kind Property for a 1031 Exchange
Now that you know the rules of a 1031 exchange, it is important to choose a QI as well as consult with a tax professional. You can find more information on the rules of a 1031 exchange and reporting an exchange for tax purposes from the IRS.
Are you in search of a 1031 Exchange replacement property, particularly a DST? We have dozens of institutional-grade 1031 Exchange properties to choose from. Sign up for a free account to view our current inventory.
Please note: 1031RPS.com and its associated personnel are not tax professionals, and they recommend investors consult with their tax advisor to ensure their 1031 Exchange is within the IRS guidelines established.