1031 real estate exchange rules define how to go about deferring federal and state capital gains and recaptured depreciation taxes when selling and replacing a real property investment. A 1031 exchange, or Internal Revenue Code (IRC) Section 1.1031, allows any entity, both U.S. residents and foreign non-residents, to defer or postpone the payment given certain 1031 real estate exchange rules are strictly followed. The first step is to be aware that the taxes can be deferred indefinitely or until the replacement property is sold. Taxes, both federal and state, along with a twenty-five percent recaptured depreciation tax, can amount to upwards of 40 percent of the property’s sales price. If you could be given up to 40 percent of the real estate sales price interest free to use towards acquiring replacement property, wouldn’t you ask what the 1031 real estate exchange rules and requirements are?
Five Key 1031 Real Estate Exchange Rules
A 1031 exchange can be both simple and complex. There are different types of exchanges. A forward exchange is when the taxpayer sells and then acquires, while a reverse exchange allows the purchase of the replacement property before the old property sells. An improvement exchanges uses the exchange proceeds towards improvements to the new property. Given six months advance planning, a leasehold improvement exchange allows the taxpayer to build on land or improve property already owned. A simultaneous exchange is when a taxpayer sells and buys in the same day. Each exchange follows the same set of rules. Each exchange has intent and supporting facts.
Rule Number One – Proper Intent
Property is held in the productive use of a trade, business or for investment. In other words, the property’s primary use is not personal. Primary residences are not eligible for 1031 exchanges unless the character is changed; no longer claiming it as a principal residence on federal tax returns and the property is rented out at fair market rent.
Rule Number Two – Like-Kind
Real property must be exchanged for like-kind real property. The like-kind factor is determined on whether the title conveyed is similar, rights of the parties, interests of the parties, extent of interests and whether the real property is located in the United States or internationally. Does the state recognize the interests as real or personal property? Real property is not like-kind to personal property.
Rule Number Three – Qualified Intermediary
Engaging a qualified intermediary to accommodate the 1031 exchange is required to prevent the Internal Revenue Service from challenging whether the taxpayer has constructive receipt or access to the exchange proceeds. Once a taxpayer receives a check at the closing or a note payable if providing seller financing, a tax is triggered and in effect the benefit of the 1031 exchange has been negated. A qualified intermediary cannot be what is considered a disqualified person or entity or person who has been an agent of the taxpayer two years prior to initiating the exchange. There are exceptions.
Rule Number Four – Equal or Greater Value
To defer the entire realized gain, the net purchase price must exceed the net selling price. Partial exchanges are acceptable, but if not enough of the value is being replaced, it may not make sense to initiate the exchange because the tax paid will be the same if an exchange is completed.
Rule Number Five – 1031 Exchange Timelines
Each exchange, whether reverse or forward, improvement or leasehold, has an identification and replacement timeline. Following the first closing, the second leg property must be formally identified typically to the qualified intermediary no later than 11:59 PM on the forty-fifth calendar day. The exchange must be completed by the 180th calendar day post-closing. There are few exceptions to this rule but include federally declared disasters and those found on the IRS web site, terroristic or military action or taxpayers serving in combat zones.
There are many more 1031 real estate exchange rules associated with exchanges between related parties and partnerships. How long does the property need to be held to qualify for proper intent? What is required to convert the character of a primary to rental and vice versa? What are the tax implications of converting a rental to a primary?
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