A 1031 exchange is a unique investment strategy that lets you defer capital gains tax on an investment property sale. Generally, you are liable to pay state and federal taxes when you sell your real estate. However, using a 1031 exchange, you get rid of these taxes. Don’t forget, 1031 exchanges let you defer taxes, but they are not tax-free.
You must pay attention to the deadlines when doing a 1031 exchange. No relaxation is given in deadlines to the 1031 exchange investors. The IRS has set a time limit for every step involved in a 1031 exchange. You must complete your transaction within the deadline, or the exchange will no longer be valid.
1031 Exchange Deadlines –
In 1967, the Starker family had filed a case against the IRS. The dispute between IRS and the Starker family had taken place on the issue of tax deferment when the latter had acquired a replacement property after five years of selling the previous property. As a result, the IRS questioned the exchange and ordered the Starker family to pay taxes on their profit. However, the Starker family filed a case against IRS in the district court where the court’s judgment went in their favor. After that, ‘Starker Exchange’ became a synonym for delayed exchange. IRS learned that time could play a significant role in 1031 Exchanges, and the entire exchange process needs to be time driven. Following which time limit was introduced in 1031 exchanges.
45 days identification period –
Once you sell your previous property, the IRS gives you 45-days’ time to identify the new property. In case you missed the deadline, your 1031 exchange will no longer be valid. It is known as the ‘Identification Period.’ Your identification period begins the day you sell your old property (relinquished property).
There have been situations when investors failed to send written identification to the IRS before the 45th day. We suggest you keep an eye on the deadline as it will not be extended under any circumstances. However, you may get extra time in case of a natural disaster or if you are serving the army in a combat zone.
You must send written identification of the new property, containing the street address, on or before the 45th day. Once you are done with the identification process, the next job is to acquire the potential replacement property within the deadline of 180 days.
180 days exchange period –
You get 180 days to complete your 1031 exchange, which begins when you sell your old property. A lot of investors get confused while calculating the identification period and the exchange period. Every 1031 exchange investor gets 180 days to complete a 1031 exchange transaction, including the 45 days 1031 exchange period. The clock begins the day the old property is sold. Therefore, you are left with 135 days after the end of the identification period.
Property rules for 1031 exchange –
You may want to acquire more than one replacement property at the end of your 1031 exchange. Well, it’s certainly not impossible to identify more than one replacement property. You can identify and acquire more than one replacement property using any of the following rules:
- The Three-Property Rule: You can identify up to three potential replacement properties using this rule, and not all of them need to be purchased. You can acquire one, two, or all three properties. The value of the new property must be equal to the selling price of the previous property.
- The 200% Rule: You can identify any number of replacement properties so long as the value of all the replacement properties doesn’t exceed 200% of the old property’s cost.
- The 95% Rule: You can identify any number of replacement properties if the cost price of the replacement property acquired at the end of the exchange is at least 95% of the price of all identified replacement properties.
These few rules and requirements are quite significant in determining your 1031 Exchange eligibility, particularly the deadlines. You cannot negotiate the deadlines under any circumstances. Therefore, you must complete your 1031 exchange on time. Otherwise, you will not be able to defer capital gains tax. It’s recommended that you speak to experienced 1031 exchange experts before planning your investment. They may help you assess the market and make the most out of your investment.