How to determine whether your real estate sale could be a 1031 Exchange:
What did you do with the property you are selling? Did you rent it out, run your business out of it, lease it, or is it raw land? As long as it is not your primary residence, it is a viable 1031 property.
What are you going to do with the money resulting from the sale? If you want to reinvest in real estate, your new property will most likely qualify for a 1031 Exchange.
To meet the requirements of §1031, both Relinquished Property and Replacement Property must qualify. In other words, both the property you are selling and the property you are buying must be qualified property of like-kind. If not, your exchange will fail and be classified as a sale. This is so important, that it bears repeating:
TO QUALIFY AS A LIKE-KIND EXCHANGE, THE PROPERTY MUST BE BOTH (1) QUALIFYING PROPERTY, AND (2) LIKE-KIND PROPERTY.
For income tax purposes, real estate is divided into four (4) classifications. Classification is made as of the date the transaction is made. The classifications are:
Held for business use (§1231)
Land held for investment (§1221)
Held for personal use (§121)
Held primary for sale (Dealer Property)
The first two classifications – held for business and held for investment – qualify for §1031 treatment. The second two – held for personal use and dealer property – do not.
Some properties have more than one classification at the time of sale. For example, a farmer sells his farm including his personal residence. The sale or exchange is allocated between the real estate held for personal use (the personal residence) and the real estate held for use in a trade or business (the farm). Another example is the sale or exchange of a duplex where the seller lived in one unit and rented out the other unit.
Under §1031, both business and investment property qualify. And it does not require only business property for business property or investment property for investment property. You can mix the classifications. For example, you can exchange a commercial warehouse (business property) for two unimproved lots (investment property). Or, a 100 acre tract of land (investment property) for an apartment building (business property). All could qualify.
The 45-day Identification Rule
The Internal Revenue Code requires that you identify your potential replacement properties within 45 days of the closing on the sale of your relinquished property. The 45 days are calendar days, so if the 45th day is Sunday, Labor Day or the 4th of July, that day is still the deadline for identification of new properties. There are no extensions allowed.
There are two ways to comply with the 45-day identification requirement. The first way is to have already purchased your replacement property. If you meet all of the exchange value requirements by using all of your sale proceeds; purchase equal or greater in value; and have replaced any debt relief from the sale; and done so within the 45 day period following closing of your relinquished property, your exchange is complete at that point.
In the event you haven’t closed on a replacement property and met all of the exchange value requirements within 45 days, you must identify your new property. By midnight of the 45th day, you must compile a list of properties that you’re thinking about purchasing to replace the property you just sold. The list must be specific: it must show the property address, the legal description, or other means of specific identification.
The 3-Property Rule - You can identify up to three potential replacement properties without regard to fair market values of the properties.
The 200 Percent Rule – You may identify any number of properties as long as their fair market value does not exceed 200 percent of the total fair market value of all Relinquished Property (ies).
EXAMPLE – On January 1st you sell your only relinquished property for $100,000. On or before February 14th you want to identify four potential replacement properties: four condominiums selling for $75,000 each.
In doing so you will have violated the 45-day rule because the four properties identified exceed 200% of the value of the property sold.
The 180-day Exchange Rule
Section 1031 requires that you purchase one or more new properties by the 180th day after the closing of the old property. You must purchase one or more properties on your 45-day identification list.
A requirement of Section 1031 Exchanges is that you must use a Qualified Intermediary (“QI”). The QI cannot be someone with whom you have had a business or family relationship. You must use an independent organization whose only contact with you is to serve as QI. The Exchanger or a disqualified person cannot qualify as qualified intermediaries for their own exchange. A person is a disqualified person if the person is an agent of the exchanger. For example, your attorney, accountant, broker or brother are all disqualified.
The QI does not provide legal or specific tax advice to the exchanger, but will usually perform the following services:
Coordinate with the Exchangers and their advisers to structure a successful exchange.
Prepare the required documentation for the Relinquished Property (1st Leg) and Replacement Property (2nd Leg).
Provide specific instructions to escrow to affect the exchange.
Secure the funds in an insured bank account until needed for disbursement to escrow to acquire the replacement property.
Prepare, manage and provide a complete accounting of the transaction to the Exchanger and/or their tax adviser at completion of the exchange.
If and when you determine that you want to undertake a 1031 Exchange, you must involve the QI prior to closing of the sale of your relinquished property
Section 1031 requires that the taxpayer on the relinquished property be the same taxpayer on the replacement property. Examples of entities holding property are corporations, trusts, and LLCs. If ABC, LLC is in title to the relinquished property, then ABC, LLC must take title to the replacement property. If you and your spouse hold title to the relinquished property, you and your spouse must take title to the replacement property.
Equal or Up Investment
Section 1031 stipulates that in order to defer 100% of the taxes on your gain on the sale of the old property, you must buy equal or up. There are two aspects of the equal or up rule. First, you must reinvest all of the cash that is generated from the sale of the relinquished property. Second, you have to buy a property (or properties) that has a sale price equal to or greater than the net sale price of the property you sold. In calculating the equal or up value, there are two items to keep in mind. The first is debt relief. The amount of money used to pay off debt against the property attributable to first mortgages, second mortgages, secured lines of credit, etc., is debt relief. The second is cash. The amount of debt relief, plus the amount of cash that would otherwise come to you as seller, is the target replacement value that you need to reinvest in order to defer 100% of the taxes.
Can you take money out of the deal? Yes. This money (called “boot” by the IRS) is taxable, but can be taken out of the exchange without invalidating the rest of the exchange so long as properly documented. However, there are only two times when money can be taken - at closing of the relinquished property, or at the end of the exchange.
This information is not intended to replace qualified legal and/or tax advice. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.