What are the rules of a 1031 exchange? The rules and requirements of a 1031 exchange can be overwhelming for any individual looking to execute a 1031 exchange for the first time. Although there is much to know, we’ve compiled the basic elements so you can quickly familiarize yourself with the vocabulary and standard questions that you will be asked by a Qualified Intermediary.
1031 exchange rules and guidelines must be closely followed from start to finish in order for a 1031 exchange to be valid. Requirements may vary depending on whether you’re selling residential or commercial property, the state in which you live, and the timeline of when the property is sold.
Although there are many guidelines to be followed, the primary 1031 exchange rules and requirements are:
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.
Property Identification Timeline
Post-closing of the first property, the Exchangor has 45 calendar days to identify to either the accommodator or the closing entity the addresses of the potential replacement properties. In a reverse exchange where either the replacement or 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.
Exchange Timeline
Within 180 calendar days following the closing of the first property–or extension of the Exchangor’s tax return when the relinquished property closes after October 15th— the property must be purchased.
Trading Up
The net sales price 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, known as a partial exchange. Debt and equity in the replacement property must be equal to or greater than the debt and equity in the relinquished property. Additional equity or cash in the replacement property offsets debt. Additional debt does not offset equity.
Fact Patterns and Intent
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 or ten percent of the rental overnights per year? If so, the character may resemble a second home.
Related Party
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), including:
- Members of the same family (siblings, spouse, ancestors, and lineal descendants)
- Corporation where more than 50 percent of the value of the stock is owned directly or indirectly by or for one particular individual
- Two (2) corporations that are in the same controlled group (as defined in subsection (f))
- A grantor and a fiduciary of any trust
- A fiduciary of one trust and the fiduciary and/or beneficiary of another trust where the same person is the grantor for both trusts
- A fiduciary of a trust and a beneficiary of the same trust
- Corporation where more than 50 percent of the value of the stock is owned directly or indirectly by or for one particular trust or by or for the grantor or fiduciary of the trust
- An organization qualified under Section 501 of the Internal Revenue Code (relating to certain educational or charitable non-profit organizations) which is controlled directly or indirectly by a specific person or, if such person is an individual, by members of the family of such individual
- A corporation and a partnership if the same person or persons own:
- More than 50 percent in value of the outstanding stock of the corporation, and
- More than 50 percent of the capital interest, or the profits interest, in the partnership
- An S corporation and another S corporation or a C corporation if the same person or persons own more than 50 percent in value of the outstanding stock of each corporation
- A partnership and a person owning, directly or indirectly, more than a 50-percent capital interest or a 50-percent profits interest, in such partnership
- Two partnerships in which the same person or persons own, directly or indirectly, more than a 50-percent capital interest or a 50-percent profits interest, in both partnerships
- An executor of an estate and the beneficiaries of the estate.
A testamentary trust created by a husband and an inter vivos generation skipping trust created by a wife are not related persons because the trusts did not have the same grantor per Private Letter Ruling 9224008. Investors may be able to eliminate related party transaction issues by changing the ownership of the related party, such as transferring or disposing of interests in a partnership or shares in a corporation to an unrelated third-party, in order to get the related party’s ownership interest below the 50-percent level.
It appears that the constructive ownership rules under Section 267(c) of the Internal Revenue Code apply in determining the ownership of stock, capital interest, or profits interest.
Related Party Transactions
Related party 1031 Exchange transactions occur when you sell your relinquished property to a related party or you buy your like kind replacement property from a related party. Related party 1031 Exchanges are permitted provided you follow specific rules and guidelines issued by the Internal Revenue Service.
If the old property is sold to a related party, the property must be held for two years before selling or the tax deferred by the 1031 exchange is due. You can purchase the replacement property from a related party only if they are also initiating a 1031 exchange.
Related party issues can also be avoided altogether if the related party relationship is eliminated prior to structuring and completing the 1031 Exchange transaction. Related parties include, but are not limited to, immediate family members, such as brothers, sisters, spouses and ascending and descending lineal descendants. Related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.
Corporations, limited liability companies or partnerships in which more than 50% of the stock, membership interests or partnership interests, or more than 50% of the capital interests or profit interests, is owned by the taxpayer is considered to be a related party.
Lineal Descendant
Lineal descendants are the direct line of relationship flowing downwards from an individual starting with his children, grandchildren and their children and so on.
If you’re still asking yourself what are the rules of a 1031 exchange and would like additional information about how exchanges work, we’ve provided details on each rule below. We also invite you to contact us with any questions you have at 1-800-227-1031.
Eligible 1031 Property Types
The following real property examples are eligible for 1031 consideration:
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What Is Not Eligible?
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Though this article is not intended to be comprehensive, we do hope that it helps to begin to build your foundation of knowledge around 1031 exchanges. Should you have any further questions or would like clarity around one of these sections, please don’t hesitate to reach out to us via phone at 1-800-227-1031 or submit your question through our consultation form below. We look forward to hearing from you.
