Section 1031 of the IRS Code provides an exception that allows investors to defer paying tax on the gain from a real estate sale if the investor reinvests the proceeds in similar property as part of a qualifying like-kind exchange. The six criteria that must be met for an exchange to qualify under section 1031 are:
- Held for Investment
- 45 Day & Identification Rule
- 180 Day Rule
- Qualified Intermediary/Exchange Facilitator
- Title Requirements
- Reinvestment of Cash/Equal or Up Rule
Held for investment
The use of the property is the key. First, the IRS specifies that both the property sold and the property replaced must be held for “productive use in a trade or business or for investment.” There is no statutory holding period requirement; however, the length of time can be a very important indicator of the intent of the tax payer. There are several rulings that indicate that a period of more than a year is reasonable. What is unclear is how much less than a year can still be satisfactory (which is dependent on other factors in the use of the property). It must be clear that the intent of the tax payer was to hold the property in productive use, not simply immediately resell it.
Second, any property held for income or used to produce income can be exchanged for a like-kind investment so long as it is of “the same nature, character and class.” All investment real estate is considered “like-kind.” Two caveats to this that investors need to be aware of are that 1) the definition of real estate is determined by individual states and can vary depending on where the property is located and 2) property located in the United States and Protected Territories of the United States is not like-kind to foreign property.
Investors have exactly 45 days from the day the sale of their old property closes to either purchase and accept ownership of replacement properties or make a list identifying the properties they might want to buy. The list must adhere to the following:
- Provided in writing (generally to the Qualified Intermediary)
- Include specific identification, so clear that an auditing IRS agent could drive to the exact property
- Should include no more than three property options
- If more than three properties are listed, the combined purchase price of all the properties on the list can be no more than twice the selling price of the old property
- If more than three properties must be listed, and if the combined purchase of all the properties on the list is more than twice the value of what was sold, then the only way to complete a successful exchange is to purchase at least 95% of the value of the entire list
The 45 day deadline and the criteria for identifying replacement properties outlined above have tripped up more than one investor. There are no exceptions and no extensions to this rule.
180 Day Rule
Section 1031 requires that investors purchase the replacement property by the 180th day after the closing of the old property. The purchase must be one or more of the properties on the 45 Day Identification List. There are no exceptions and no extensions to this rule.
Qualified Intermediary/Exchange Facilitator
The IRS states that “taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable . . .One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary . . .” A qualified intermediary, or exchange facilitator, is an unrelated third party who does not have any agency or family relationship with the investor. The qualified intermediary must be involved at or prior to the sale of the original investment property.
However the taxpayer holds title to the old property is how the taxpayer must take title to the new property. Any entity, whether corporate or personal, that can own real estate can take advantage of the 1031 Exchange opportunity; however, it must be the same taxpayer for both old and new properties.
Reinvestment Requirements/Equal or Up Rule
To defer tax on all of the profit, all cash proceeds must be reinvested. In addition, the investor must purchase property or properties of at least equal or greater value than what was sold. This “Equal or Up” rule can be understood in one of two ways:
- Cash + debt relief = reinvestment target
- Net Sales Price of the Old Property = reinvestment target
It is still possible to complete a valid exchange when purchasing less than what was sold or when taking cash proceeds. The process is called taking “boot” and a qualified intermediary can advise investors on the ramifications of such an action.
1031 Exchanges are an excellent investment strategy that has intimidated many uninitiated investors. However, by complying with the six basic rules for the like-kind investment swap, the leverage gained can create exponential portfolio growth. An experienced and reputable qualified intermediary can help investors navigate this process to access the benefits offered.