1031 Exchange Basics (Concise Overview)

The 1031 Exchange allows an investor to sell property they have been HOLDING as investment/rental property or property they have used in their business and acquire like-kind replacement property that they INTEND to HOLD as investment property or property to be used in their business without incurring any capital gain tax liability.


By deferring 100% of your capital gain tax liability you retain 100% of your net cash proceeds from the close of the transaction to reinvest in the next like kind replacement property and allows 100% of your cash to continue working for you instead of the Federal government.


Qualified Use Test


The key CAPITALIZED words are important, because the investor/taxpayer/exchangor must have the INTENT to HOLD any property involved with a 1031 exchange for investment or business property in order to satisfy the Qualified Use Test.


If you actually INTEND to buy, fix-up and then flip a property you do not have the INTENT to HOLD and therefore do not satisfy the Qualified Use Test and technically do not qualify for 1031 exchange treatment. Your INTENT is to actually hold the property for sale (inventory) pending completion of repairs and improvements. Typically the gain on the sale of property held for sale is taxable as ordinary income and can not be deferred pursuant to Section 1031.


Like Kind Replacement Property


Also, to clear up some misinformation that has been circulated for years, ANY type of real estate is considered to be like-kind to ANY other type of real estate for 1031 exchange purposes provided the taxpayer has HELD the properties for investment or use in their business and therefore satisfied the Qualified Use Test.


So, you can sell an apartment complex and buy a commercial/industrial property, or you could sell a couple of single family homes and acquire a retail center, or you could sell vacant land and acquire multi-family property (apartments), etc.


Types of 1031 Exchanges


There are three basic types of 1031 Like Kind Exchange transactions: Forward (Delayed), Reverse or Build-To-Suit 1031 Exchanges.


The forward 1031 exchange allows the investor to sell his or her relinquished property first and then acquire the replacement property later.


The reverse 1031 exchange allows the investor to acquire his or her replacement property first and then sell the existing relinquished property. This structure eliminates the risk and stress involved with a forward 1031 exchange and the 45 day identification period.


The final structure is the build-to-suit 1031 exchange where the investor can use his or her exchange proceeds to purchase replacement property and construct improvements on the property as part of the 1031 exchange transaction.


Deadlines


You have two time frames to adhere to when you are structuring a 1031exchange transaction. They both start running the day you close on your relinquished (sale) property or replacement (acquisition) property. So, if you closed your transaction and title has been conveyed today, then tomorrow would be day number one for both your 45 and 180 day deadlines.


45 Day Identification Period


You have 45 calendar days to identify what you intend to acquire (or sell in a reverse exchange). Most taxpayers will use the three (3) property rule, which means you identify up to but not more than three (3) properties as potential like kind replacement properties. You may acquire one, two or all three of the identified properties (the 1031 exchange is a great method for investors to diversify from one to many or to consolidate from many into one properties and restructure their portfolios accordingly with out paying any capital gain taxes).


180 Day Completion Deadline


You have a total of 180 calendar days in order to complete your 1031 exchange and receive title to your replacement property(ies) (or transfer title to your relinquished property in a reverse exchange). It is NOT 45 plus 180 calendar days. It is a total of 180 calendar days from the close of your relinquished property.


Notice that I have indicated in both cases that it is calendar days, so that if the actual due date falls on a Saturday, Sunday, or holiday, the due date is NOT extended and does fall on that date.


Qualified Intermediary (Accommodator)


The investor must make sure that he or she has retained the services of a professional Qualified Intermdediary and the Qualified Intermediary MUST be assigned into the Purchase and Sale Agreement and Escrow Instructions (if any) BEFORE the transaction closes. If the transaction closes before the Qualified Intermediary has been assigned into the transaction it automatically becomes a taxable transaction and there is NO way to do a 1031 exchange.


Exchange Fees


The majority of the major Qualified Intermdiaries will charge about $750.00 for forward 1031 exchanges, $4,000 to $5,000 for a reverse or build-to-suit 1031 exchanges, and more if the transaction is exceptionally large.


Legal Disclaimer


This article does not include all of the 1031 exchange requirements, is not intended to replace competent legal and tax advice, and is only a concise and abbreviated overview of the 1031 exchange code, regulations and guidelines.


More to Come


I will be submitting a more complete article entitled Introduction to 1031 Like Kind Exchanges shortly.