by: Chelsea Kapple
A 1031 exchange, commonly referred to as a “like-kind” exchange, is the swap of one piece of property (“relinquished property”) for another piece of similar property (“new property”). If done correctly, this allows a taxpayer to defer taxation on the gain of the relinquished property, making it one of the most beneficial strategies available in the tax code.
Qualifying for a 1031 Exchange
To qualify as a 1031 exchange, the disposition of the relinquished property and the acquisition of the new property must be one integrated transaction, meaning that a taxpayer cannot simply sell one property and use the cash proceeds to purchase a new one at any time. Instead, they must follow strict rules to qualify for favorable tax treatment. Though the rules are complex and nuanced, the type of property, timing of exchange, and control of transaction proceeds are three important areas to understand to ensure a successful exchange.
Property Type Requirements
First, the taxpayer must exchange the correct type of property. Under the Tax Cuts and Jobs Act of 2017, 1031 exchanges are limited to real property held for use in a trade or business or for investment. Real property is generally defined as land and anything permanently built on or attached to land. Personal real property, such as a home residence, does not qualify. Inventory, stocks, bonds, notes, partnership interests, or other securities also do not qualify.
Timing and Identification Rules
Second, the taxpayer must follow certain timing limitations. From the date the relinquished property is sold, the taxpayer has 45 days to identify replacement properties. Replacement property must be received and the exchange completed by the earlier of the following: 1) 180 days after the sale of the relinquished property or 2) the due date of the income tax return (including extensions) in the year the relinquished property was sold. Identified properties must be made in writing, signed, and delivered to the seller of the replacement property or qualified intermediary.
Identification Restrictions
To increase the chances of a successful exchange, the taxpayer should identify more than one property, but there are restrictions on the number and value of properties that can be identified. One of the following three tests must be met:
- Taxpayer identifies 3 or fewer properties.
- Taxpayer identifies any number of properties, but the aggregate value of those properties does not exceed 200% of the value of the relinquished property.
- Taxpayer identifies any number of properties with no limitation on value, but at least 95% of the identified value must be acquired.
The Role of a Qualified Intermediary
Finally, the taxpayer cannot take control of the cash or other proceeds from the relinquished property sale until after the exchange is complete. For this reason, a qualified intermediary is typically used to facilitate the trade. The qualified intermediary holds the funds from the relinquished property’s sale until the new property is purchased.
Preparing for Your 1031 Exchange
If you are considering a 1031 exchange, it is vital to understand the rules necessary to qualify for tax deferral before beginning the process. Enlisting a qualified intermediary and trusted tax advisor to guide you through the process can help ensure the 1031 exchange is successful.