Regardless of being a seasoned realtor to someone new to the 1031 exchange, it’s true that the 1031 exchange can be a challenging process. With so many rules to consider and conducting everything within the severe timeline, there’s a lot to keep in mind when it comes to this 100-year-old tax deferral treatment.
However, regardless of the rules and time crunch associated with it, a 1031 exchange can help you defer the taxes on your capital gains by investing the entire proceeds in a replacement property.
So, if you are considering doing a 1031 exchange, here are the four facts that help you better understand the process.
Understanding How IRS Defines The Exchange
With an aim to avoid taxation on real estate investment and encourage more active investment, the IRS added section 1031 back in 1921. The section defined 1031 exchange as a like-kind exchange where a real estate property or a property solely held for investment purposes is swapped by a ‘like-kind’ replacement property to defer the capital gain taxes on the old property.
If we talk about the terms, a relinquished property is the property being sold, and replacement property is a like-kind property you invest your proceeds in. Moreover, ‘like-kind’ means that the relinquished and replacement property must only be an investment property. This means you can not use the 1031 exchange to swap personal residence or vacation homes.
Identifying Eligible Replacement Properties
As stated above, you must only reinvest in a like-kind property to successfully complete a 1031 exchange. However, the IRS defines like-kind properties differently than you think. According to the IRS, a like-kind property is a real estate property held only for investment purposes.
This means that you can swap a relinquished property with any property, given it is held solely for investment purposes. For instance, you can sell office space to invest in a senior care home or even an oil field.
But that’s not that. If you want to diversify your investment portfolio, you can also invest in DSTs, NNN properties and even qualified opportunity zones to defer the taxes. However, you must keep the 1031 exchange timeline 2022 in mind.
Understanding 1031 Exchange Timeline
To successfully complete a 1031 exchange, you must identify upto three replacement properties within 45 days of selling your relinquished property. This doesn’t mean that you have to reinvest in all three properties. In fact, you have to identify three replacement properties only to have an option in case you can not reinvest in the first option.
Moreover, once your 45-day ID period ends, you must close on the replacement property within 180 days of selling your relinquished property OR 135 days of completion of the 45-day ID period.
You can invest in any one replacement property or even invest in all three, as long as you invest the entire proceeds. Furthermore, it is recommended to identify at least one DST property when identifying your replacement properties.
Following The Three Replacement Rules
Conducting a 1031 exchange requires advanced planning. Here are the main 1031 exchange rules you must keep in mind.
- You must identify upto three replacement properties within 45 days of selling the relinquished property.
- You must close on the replacement property within 180 days of selling the relinquished property.
- The replacement property must be of equal or greater value than the relinquished property.
While the first two were made pretty clear, the third needs further explanation. To reinvest in a replacement property that is of equal or greater value than the relinquished property, you can do EITHER of the following things-
- Identify upto three replacement properties regardless of their fair market value.
- Identify multiple properties as long as the combined value of all the chosen replacement properties does not exceed 200% of your proceeds.
- Identifying multiple properties as long as the combined value of all the chosen properties does not exceed 95% of your proceeds.
As long as you keep the 1031 exchange timeline 2022 and rules in mind, the 1031 exchange can be a streamlined process. However, to get started, you must connect with a qualified intermediary. Moreover, you can also connect with registered investment advisors who will help you select the right property.