If you are like most real estate investors looking to defer the payment of capital gain taxes, then doing a 1031 exchange may be the solution. A 1031 exchange is a section of the IRS tax code that allows taxpayers to forego the payment of capital gain taxes when selling an investment property or properties.
In this article, you’ll learn more about some of the basic requirements guiding a 1031 exchange procedure.
- Qualified Intermediary Requirement
If you have decided to defer the payment of capital gain taxes by doing a 1031 exchange, you must employ the service of a qualified intermediary to facilitate and handle the exchange process.
A Qualified Intermediary is a third-party individual that facilitates the exchange process, prepares the legal document, receives the sale proceeds, and purchases the replacement property on behalf of the taxpayer. A taxpayer cannot use their attorney, real estate agent, or a relative as their QI.
More importantly, some states in the US require that a QI be compliant with laid down rules regarding insurance and how the realized proceeds must be held.
- Like-Kind Requirement
When doing a 1031 exchange, the IRS guideline requires that the property or properties that you exchange in a 1031 exchange are like-kind. What this means is that the properties in exchange must be held for trade or investment purposes. However, this doesn’t mean you must exchange the same type of property. For example, if you’re relinquishing a fourplex, you don’t need to purchase a fourplex as replacement property.
- Time and Identification Requirement
To complete a 1031 exchange, there are two important timelines you need to keep in mind. According to the IRS, upon the sale of your relinquished property, you must identify your replacement property within 45 days. And you have 180 days to close on the purchase of your desired replacement properties.
The IRS also requires that details about the replacement property or properties must be identified in a written document and delivered to your designated qualified intermediary.
- Purchase Price Requirement
To be able to successfully defer capital gain taxes, the price of your new or replacement property or properties must be equal or greater in value than your relinquished property. For instance, if you sold your relinquished property for $200k, your replacement property value must be either $200k or above to avoid receiving boot.
Also, if there is mortgage debt on the relinquished property, the IRS requires that the replacement property price must be equal or higher than the mortgage paid off at the time of the sale of the relinquished property.
- No Constructive or Actual Receipt of Exchange Funds
According to the IRS, individuals doing a 1031 exchange must not be in control or have access to the sale proceeds during the exchange. All cash proceeds realized from the sale of the relinquished property must be held by the qualified intermediary. In a nutshell, if you are in control of the exchange funds directly or indirectly, you risk disqualifying the entire exchange process.
- Same Title Holder Requirement
If you are familiar with the 1031 exchange, you may be aware of the same taxpayer rule. In a 1031 exchange, the IRS requires that the titleholder of the relinquished property must be the same individual that takes up the title of the replacement property. Please remember that in the case, the focus is more on the tax identity of the individual and not just the name of the taxpayer.
- Must Report the Exchange to the IRS
Before your 1031 exchange can be finalized, you must report the exchange with your tax returns to the IRS during the year you sold your relinquished property. You will need to file Form 8824 in the year you sold the old property regardless of the year the exchange was completed.
A 1031 Exchange or Like-Kind exchange is a great tax strategy for real estate investors to defer the payment of capital gain taxes but it is not a simple process. Before doing a 1031 exchange, ensure that you have solid knowledge about the process and that you have enlisted the help of a reputable exchange company to guide you.
If you’re currently considering a 1031 Exchange, you may be interested in reading our piece on 1031 Exchanges and Delaware Statutory Trusts.