1031 Exchange Explained

What is a 1031 Exchange?

A 1031 tax-deferred exchange allows investors to reinvest the profits from the trade of investment property in one or more replacement properties without inviting immediate federal (and most state) capital gains taxes on the appreciated value. When the sale and purchase fulfill the 1031 exchange standards, taxes are delayed until the newly procured property is sold. This deferral strategy can be duplicated through any number of exchanges until the tax liability crosses into the individual’s estate upon death.

 Understanding 1031 Exchange

1031 Exchange enables investors to strategically manage their real estate investments while maintaining equity, diversifying portfolios, and gaining tax advantages. To assist investors with completing their 1031 exchanges on time, Companies providing 1031 Exchange should maintain a database of investment properties suitable for 1031 exchanges. These investment properties range from multi-family properties to TIC (tenants in common) properties to net-leased investments.

Access to a nationwide database provides potential advantages to real estate investors. For example, let's say an investor wants to diversify geographically and get into a growing real estate market in the Phoenix, Arizona area. The problem for many investors with this strategy would only be finding the right property to invest in there within the 1031 deadlines.

Outlines of 1031 Exchange Process

In a 1031 exchange, Qualified Intermediaries hold the exchange funds on behalf of the investor. The agreement of sale with the seller of the replacement property is assigned back to them which allows the deposit to be withdrawn from an exchange account. The assignment is often introduced when the Agreement of Sale is signed. However, it can be approved by the Seller at any time to get the deposit funded from the exchange account. If due to some reason, the Assignment is not signed by the Seller, your sponsor/broker should provide written notification of the assignment and have it presented to the Seller. The notification will include a compliance clause guaranteeing the Seller that 1031 exchange will not impact the Seller in any manner or lead to an increment to the Seller’s costs. The Assignment helps get rid of any issues with constructive receipt of the exchange funds.

Time Periods governing 1031 Exchange

Time periods are extremely critical while performing a 1031 exchange. The 45-Day Identification and 180-Day Exchange Periods start with the transfer of the relinquished property to a buyer. When was the Agreement of Sale for the replacement property signed is not crucial, however, one needs to be sure that the scheduling of the closing is done after the relinquished property is assigned to the buyer. In the cases when the investor's personal finances paid earnest money deposit either for comfort or because the Agreement of Sale for the replacement property was signed prior to the closure of the relinquished property and the exchange funds were available, the deposit can be refunded from the exchange funds at the procurement of the replacement property. Ideally, an Exchange Officer will check if the deposit was paid out-of-pocket and allow it to be reimbursed at the time of closing of the replacement property. The reimbursement cannot be paid directly to an investor. 

Guidelines around 1031 Exchange Replacement Property

Investors aren’t bound to obtain everything they identify on the document, but the identification needs to abide by one of these rules:

1.           The Three-property rule

2.           The 200% rule

3.           The 95% rule

As dictated by the three-property rule, one can identify up to three pieces of real property which have a great aggregate fair market value.

As long as three properties are identified, the total fair market value of all of these properties has no bearing on the 1031 Exchange. Taxpayers follow this rule diligently as it is straightforward in nature. The total costs of all the three identified properties are immaterial, and investors can acquire any number of identified properties - one, two or all.

Another important rule to be followed is the second rule also referred to as the 200% rule. This rule enables investors to identify any number of properties as long as the consolidated value of all the identified properties doesn’t exceed 200% of the relinquished property’s value.

The last rule, which is a bit tricky and is followed the least is the 95% rule. As in the 200% rule, the 95% rule also enables investors to identify unlimited possible replacement properties, and however, unlike the 200% rule, this rule also permits the value of those identified properties to top 200%. So, the 95% rule allows an unlimited number of properties of infinite combined fair market value.

Under section 1031, a taxpayer may defer profit recognition by exchanging for like-kind property. The replacement property cost must be equal to or exceed the net sales price of the relinquished property, and the taxpayer must replace all equity and debt.

1031 Exchange enables your money to churn the maximum profit for you. However, the exchange process is extremely complex in nature and it would be wise to seek guidance from expert professionals. I have extensive experience in handling highly profitable exchanges for our varied client base.

For consultation and assistance regarding 1031 exchange call - call me at 415.336.9695