“1031 exchange” gets its name from Section 1031 of the IRS’s tax code. This section of the code states that if an individual exchanges one investment property for another via a 1031 exchange, they may be able to defer capital gains or losses that they would otherwise have to pay at time of sale.
Various reasons for which a Seller may want to utilize a 1031 exchange include exchanging non-productive real estate for income-producing real estate, moving the location of business or rental property, exchanging into more desirable investments, or estate planning.
Four Key Requirements for Exchanges
Qualified Use | To conduct a 1031 exchange, both the transferred property and the acquired property must be held for investment purposes or used in a business or trade.
Fair Market Value and Equity | For the exchanger to defer all of the capital gain, the acquired property must have a fair market value greater than or equal to the fair market value of the transferred property. The exchanger must also reinvest all of the equity held in the old property as equity in the new property.
Title | Generally, the exchanger must hold title in the new property in the same way as they held title in the old property.
Exchange Agreement | An exchange agreement with a qualified intermediary must be fully executed by the closing of the relinquished property. This prevents constructive receipt of the sales proceeds.
The exchanger must identify the replacement property in writing and send it to the qualified intermediary within 45 days from the closing of the relinquished property.
The exchanger may identify up to 3 replacement properties without regard to fair market value of either the relinquished property or replacement properties. The exchanger may acquire one, two, or all three of those replacement properties that were identified.
If more than 3 replacement properties are identified, the combined fair market value of all the identified properties cannot be greater than 200% of the fair market value of the relinquished property.
If more than 3 replacement properties were identified and their combined fair market value is greater than 200% of the fair market value of the relinquished property, then the identification will only be successful if the exchanger acquires 95% of all property identified.
Qualified Intermediary (“QI”)
The most commonly used method of effecting a 1031 exchange is through the use of the Qualified Intermediary Safe Harbor set out in the tax code. The QI’s relationship as facilitator is governed by the exchange agreement which must be entered into before the closing for the sale of the relinquished property. The tax code prohibits an attorney, CPA, or other agent of the exchanger to serve as the QI if they have represented the exchanger in any matter during the last 2 years prior to the exchange.
The replacement property must be acquired the earlier of:
(1) 180 days from the closing of the sale of the relinquished property -or-
(2) the due date for the exchanger’s tax return (including extensions) for the year in which the relinquished property was sold