1031 exchanges or tax-deferred exchanges of property lets any investor defer capital gains tax when an investment property is exchanged for another like-kind property. The IRS states that assets exchanged using 1031 exchanges must be held for use in trade, business, or for investment purposes. In other words, any investment property can be exchanged for another using a 1031 exchange. Only personal properties are an exception. One out of all the rules established by the IRS requires investors to involve a Qualified Intermediary in their respective 1031 exchanges. In fact, a 1031 exchange is impossible without the participation of a Qualified Intermediary.
Who is a Qualified Intermediary?
A Qualified Intermediary is a person that handles and facilitates 1031 exchanges. From finding a buyer for your relinquished property (if required) to locating and acquiring the replacement property, everything is done by them. In order to ensure that a 1031 exchange gets completed within the specified time limit and investors don’t need to get on the street for locating replacement properties, the IRS has made the involvement of Qualified Intermediaries compulsory in 1031 exchanges.
Don’t mess with the deadlines –
Though the majority of work is done by the Qualified Intermediaries, you, as an investor, must look after a few things. For instance, you must keep a watch on the deadlines and complete your exchange within the specified time limit as there is no provision for extension of deadlines in the 1031 tax-deferred exchange of property. You must calculate your 1031 exchange and identification period in advance.
- 45 Days Identification Period – As soon as you close on the sale of your relinquished property, the next task is to identify a potential replacement property within 45 days. This time limit of 45 days is known as the Identification Period. Written identification of all the identified replacement properties (if there is more than one) must reach the IRS on or before the midnight of the 45th day.
- 180 Days Exchange Period – This isn’t another deadline, but the overall time limit for completing a 1031 exchange. You get 180 days in total to complete your exchange, where the first 45 days are given to identify the replacement property that must be acquired within the next 135 days.
Identify as many replacement options as you like.
While doing a 1031 exchange, one thing that you must keep in mind is that the cost of the new property must be equal to or greater than that of the relinquished property. In addition, the debt on both relinquished and replacement properties must also be equal. No restriction on the number of properties an investor can acquire as their 1031 exchange replacement property. A 1031 exchange investor can identify and acquire any number of replacement properties using any of the following rules –
- The Three-Property Rule – Using this rule, a 1031 exchange investor can identify up to three replacement properties. Not all the identified replacement options need to be purchased, and it entirely depends on you if you want to buy one, two, or all identified properties.
- The 200% Rule – This rule enables an investor to identify any number of replacement properties as long as the total cost of all the identified properties doesn’t exceed 200% of the price of the old property.
- The 95% Rule – This property rule lets you identify any number of replacement properties as long as the cost of the property received at the end of an exchange is at least 95% of the price of all identified properties.
A genuine case of a tax-deferred exchange –
Catherine Walter, an enthusiast 1031 exchange investor, recently closed her third 1031 exchange in California. Catherine had a couple of investment properties that weren’t generating as much revenue as she would want them to. So she decided to relinquish one of them. The property which she relinquished worth $5 million. Now, if she had sold it out instead of doing a 1031 exchange, she would have to pay taxes on the capital gains.
Property’s value = $5 million
State Tax = 15% (approx) = $750K
Federal Tax = 20% (as the property was held for more than ten years)
Net profit = Property’s value – Taxes = $(5000,000 – 1750,000)
= $3.25 million
As you can see, Catherine would have lost $1.75 million in taxes had she sold her property. However, since she went for a 1031 exchange, she saved those $1750K. Out of those $5 million, she invested $4.5 million in the new property, whereas the remaining $500K went into a DST that she finalized after going through the 1031 DST properties list that she had.
At the end of her exchange, Catherine had –
A new investment property worth $4.5 million, plus fractional ownership in a large institutional-grade property (through DST investment).
You can also close your 1031 exchange like Catherine –
Spending a portion of 1031 exchange proceeds in DSTs is quite common. Accredited 1031 exchange investors often do that, and it provides them tremendous benefits. However, before you proceed with your investment, it’s important that you consult an experienced 1031 exchange advisor.
Talk to an advisor if it’s your first exchange.
As you can see, the stiff deadlines can worry any investor. Therefore, if it’s your first 1031 exchange, you must consult an experienced 1031 exchange advisor or expert before investing. A good advisor can help you in understanding this unique tax-deferred exchange thoroughly. Moreover, they can also help you pick a suitable 1031 exchange. For example, you can also buy a replacement property first and then close on the sale of your relinquished property. This kind of 1031 exchange is known as a reverse exchange. Basically, there are four kinds of 1031 exchanges – simultaneous, reverse, delayed/forward, and built-to-suit or Improved Exchange. Therefore, it’s important that you choose your 1031 exchange wisely, and an advisor can help you with this.