A 1031 Tax Deferred Exchange allows real estate investors to defer the payment of capital gains taxes when selling an investment property and exchanging into another investment property. There are several types of exchanges available to investors depending on how they wish to structure their transaction.
Investors have the ability to structure their exchanges in several ways. Depending on the investor’s situation any of the four exchange types listed below could be a viable option:
- Simultaneous Exchange
In a simultaneous exchange the relinquished property is sold and the replacement property acquired on the same day, with concurrent closings. The simultaneous exchange is rare and investors should still use an Exchange Accommodator when doing a simultaneous exchange.
2. Delayed Exchange
The most common method of exchanging, the delayed exchange, allows investors to sell a property and then acquire replacement property within 180 days.
3. Reverse Exchange
The reverse exchange allows investors to acquire replacement property prior to selling. The reverse exchange can be more complicated however, as investors cannot own both the new replacement property and (soon to be) relinquished property at the same time. An Exchange Accommodating Titleholder will need to go on title to one of the two properties involved in the exchange. Investors considering a reverse exchange should contact exchange company well in advance (2 weeks) of closing on the replacement property. For more information about the reverse exchange, please call your exchange company for a free consultation.
4. Construction/Improvement Exchange
The construction exchange allows investors to use exchange proceeds to build on land or improve an existing property. The construction/ improvements exchange is often used to acquire a ‘fixer’ and do improvements on the existing structure. The pitfall with a construction/improvement exchange lies in the fact that all exchange funds need to be spent on or before the 180th day of the exchange.
Basic Exchange Guidelines
Strict adherence to the guidelines set forth within the tax code is required for a successful exchange. Investors should be aware of four basic requirements when entering into a delayed exchange, and should seek the advice of their tax accountant or attorney to ensure proper adherence to the tax code. The four basic requirements for a successful exchange are:
- Property Qualifications
The internal revenue code requires that the properties involved in an exchange must be held for productive use in trade or business or for investment, and they must be “like-kind”.
The IRS provides a maximum of 180 days to complete an exchange. The timeline begins upon the close of escrow (COE) of the relinquished property. The replacement property (or properties) must be acquired on or before midnight of the 180th day. No Exceptions! In addition the IRS requires that all potential replacement property be identified by midnight of the 45th day. If the replacement property (or properties) can not be acquired on or before day 180, the exchange will fail and taxes must be paid.
3. Identification Rules
Identification of all potential replacement property is required on day 45 of the exchange. Identification must be in writing and the description of the properties must be unambiguous. The IRS provides two rules for identifying replacement property:
The 3 Property Rule: The 3 Property Rule allows for identification of any three properties, of any price, anywhere in the United States.
The 200% Rule: The 200% Rule is an option for identifying more than three properties. With the 200% Rule four or more properties can be identified, however the combined value of all properties identified cannot exceed 200% of the property sold.
4. 100% Tax Deferral
To defer 100% of the capital gains tax liability, two requirements must be met Reinvest all the cash that was generated from the sale of the relinquished property and; Purchase property equal or greater in value to the relinquished property.
To learn more about 1031 exchange, please call Diana at (408)893-3812.