Summary: A 1031 Exchange lets taxpayers defer capital gains tax by selling a property and reinvesting in a like-kind property, managed by a Qualified Intermediary. The sold property is called Relinquished Property, while the new one is Replacement Property. Taxpayers must follow rules for identifying properties and complete the exchange within set time limits.
What is a 1031 Exchange?
A 1031 Exchange, also known as a like-kind exchange or tax-deferred exchange, allows real property held for productive use in a trade, business, or investment to be sold, and the proceeds reinvested into a like-kind property intended for business or investment use. This process permits the taxpayer, or seller, to defer capital gains tax and depreciation recapture on the transaction.
Relinquished vs. Replacement Property
The property sold in a 1031 Exchange is called the Relinquished Property, while the property purchased is known as the Replacement Property. The real property involved must be like-kind; most real estate is like-kind to other real estate. For instance, an office building could be exchanged for a rental duplex, or a retail shopping center for farmland.
Role of a Qualified Intermediary
During a 1031 Exchange, neither the taxpayer nor an agent of the taxpayer can receive or control the funds from the sale of the property. If the taxpayer has direct or indirect access to the funds, the 1031 Exchange becomes invalid. This is where a Qualified Intermediary comes into play, holding the proceeds of the Relinquished Property sale until it’s time to transfer those proceeds for the close of the Replacement Property.
Eligibility Criteria
To qualify for a 1031 Exchange, the person or entity must be a US tax-paying identity, including individuals, partnerships, S-corporations, C-corporations, LLCs, and trusts. It is also a requirement that the same taxpayer sells the Relinquished Property and purchases the Replacement Property for a valid exchange.
Historical Background
1031 Exchanges were first authorized in 1921 because Congress recognized the importance of reinvesting in business assets and wanted to encourage more of it. Over the years, there have been various changes and additions to the regulations governing 1031 Exchanges, with the most recent changes impacting real estate occurring in 2001.
Requirements and Rules for a 1031 Exchange
All 1031 Exchanges, regardless of the type, have a 45-day identification period and a 180-day exchange period. To comply with IRC § 1031, within 45 days of the sale of the Relinquished Property, the taxpayer must identify their potential replacement properties in writing to the qualified intermediary. The description of the replacement properties must be unambiguous and specific, using a physical address or legal description.
Identification Rules
When identifying potential replacement properties, a taxpayer must follow one of three distinct rules based on their specific exchange situation:
- 3-Property Rule: Identify up to three properties without regard to their fair market value, and close on at least one of the identified properties for the exchange to be valid.
- 200% Rule: Identify more than three properties, but the combined fair market value of all properties must not exceed 200% of the fair market value of the Relinquished Property.
- 95% Rule: Identify an unlimited number of properties, provided they acquire properties worth at least 95% of the total value of all identified properties.
Time Limits
All 1031 Exchanges have a 180-day period starting from the day of the sale of the Relinquished Property. If the taxpayer does not complete the purchase of the Replacement Property within this period, the exchange is considered closed, and taxes on the proceeds must be recognized and paid. No extensions or exceptions apply, unless the property is located in Presidentially declared disaster zone and a specific extension was granted.
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