1031 Exchange Rules for Successful Real Estate Investing

How To Do A 1031 Exchange

A 1031 Exchange is a powerful tax-deferment strategy used by some of the most financially successful investors. Prices in many U.S. cities have surpassed the “bubble levels” of a decade ago. Because of this, many real estate investors think that now is the optimal time to exchange properties in expensive markets for cash-flow properties across the country by following the 1031 exchange rules.

To do a 1031 exchange effectively, you must exchange one property for another property of similar value. In the process, you avoid capital gains, at least for a while. An investor will eventually cash out and pay taxes, but in the meantime, an investor can trade properties without incurring a sudden tax obligation. It’s an important tool for real estate investors that has become a bulls-eye for tax reform evangelists.

However, the 1031 Exchange Rules require that both the purchase price and the new loan amount be the same or higher on the replacement property. That means that if an investor were selling a $750,000 property in Dallas that had a $500,000 loan, they would have to buy $750,000 or more of replacement property with $500,000 or more leverage.

Primary 1031 Exchange Rules

Rule 1: Same Taxpayer

The tax return and name appearing on the title of the property that sells must be the tax return and titleholder that buys. A single member limited liability company (smllc) is considered a pass through to the member, consequently, the smllc may sell and the member may purchase in their individual name.

Rule 2: Property Identification

Post-closing of the first property, the Exchangor has 45 calendar days to identify the Accommodator and the potential replacement property. In a reverse exchange, where either the replacement or the relinquished property is parked, the Exchangor has 45 days to submit a final list of properties for sale or purchase.

• Three property rule - can identify any three properties regardless of value.
• Two hundred percent rule - can identify four or more properties, as long as the value does not exceed 200 percent of the property sold.
• 95-percent exception rule - if the value exceeds 200 percent, then 95 percent of what is identified must be purchased.

Rule 3: Replacement

Within 180 calendar days following the closing of the first property or extension of the Exchangor's tax return, the property must be purchased.

Rule 4: Trading Up

The net market value and equity of the property sold must be equal to or greater in the replacement property to defer 100 percent of the tax. Otherwise, the Exchangor needs to pay tax on the difference. Debt and equity in the replacement property must be equal to or greater than the debt and equity in the relinquished property. Additional equity in the replacement property offsets debt. Additional debt does not offset equity.

Rule 5: Hold Time

Though there is no hold time in the 1031 code, the Internal Revenue Service looks to determine whether the property was acquired immediately before the exchange. Was it purchased to fix and flip or held for productive use or investment? Time is one of many factors that supports the intent to hold for investment. The shorter the time, the more substantial the facts should be to support the intent. Additional supportive facts are whether the property is itemized on Schedule E or Schedule A. Investment properties are listed on Schedule E. Was the property rented? Does the level of personal use exceed 14 overnights per year? If so, the character may resemble a second home.

Rule 6: Related

The term "related person" or "related party" means any person or party, including entities, that has a relationship to the taxpayer described in Section 267(b) or Section 707(b)(1) of the Internal Revenue Code ("IRC").

Other Guidelines to Remember

• To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.” This is a very broad term, meaning that both of the properties must be “the same nature or character, even if they differ in grade or quality.” In other words, you can’t exchange farming equipment for an apartment building, because they’re not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property.
• A 1031 exchange is only applicable for Investment or business property, not personal property. In other words, you can’t swap one primary residence for another.
• In order to completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax.
• For a Section 1031 exchange to be completely tax-free, a taxpayer must not receive “Boot” from an exchange. Any boot received is taxable to the extent of gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax free. The difference is called “Boot,” which is the amount you will have to pay capital gains taxes on. This option is completely okay, and often used when a seller wants to make some cash, and is willing to pay some taxes to do so.
• The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. However, as an exception to this rule occurs in the case of a single member limited liability company (“smllc”), which is considered a pass-through to the member. Therefore, the smllc may sell the original property, and that sole member may purchase the new property in their individual name.
• The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind. This can be really difficult because the deals still need to make sense from a cash perspective. This is true especially in today’s market because people tend to overprice their properties when there are low-interest rates, so finding all the properties you need can be a challenge.
• To qualify under a 1031 exchange, you must also purchase all new properties within 180 calendar days (6 months) following the closing of the original property. An exception to this rule is if the property owner extends his tax return, in which case the 180-day window begins on the date of the extension.