Tax-deferred exchanges are approved by Section 1031 of the Internal Revenue Code, and the necessities of the code section and the corresponding guidelines or 1031 exchange requirements must be carefully met. At the point when the like-kind exchange is done correctly, then the taxes on the transaction are deferred.
The following are some of the 1031 exchange requirements:
Taxpayers or investors must exchange properties that are of like-kind. Generally, all the real estate properties are like-kind to other real estate. For personal property, the like-kind assets may be classified by a General Asset Class (GAC) and if not matched there, then by North American Industry Classification (NAICS) Product Class. If the personal property assets are not found in the GAC or NAICS, then a general like‐kind analysis may be made.
Assets that are exchanged under 1031 exchange must be held for productive use in a trade or business or held for investment.
No holding period is specifically defined under section 1031. Generally, a rough thumb rule is a holding period of two years or more. This period is considered in determining whether the purpose is met or not. For example, if a replacement property is acquired and sold immediately, that indicates that the property was gained for resale and is, therefore, dealer property or inventory and cannot qualify for tax-deferred treatment under Section 1031.
An exchange must take place when one real estate property is exchanged for another of like-kind property. The investor can sell or acquire more than one property through a 1031 exchange.
Time limits & identification requirement
A taxpayer has the identification period of 45 days to acquire or recognize the target replacement property after the transfer of the relinquished property. Properties procured within the 45-day designation period are deemed to be identified. The replacement property must be assigned in a written document, unambiguously described, signed by the taxpayer and received by the qualified intermediary between a period of 45 days.
If the investor identifies replacement property within the assigned period, the exchange period end date may be extended up to 180 days from the transfer of the first relinquished property. This provides the additional taxpayer time to complete the exchange; however, it might be necessary for the taxpayer to file a tax-filing extension to utilize the full 180 days.
No constructive or actual receipt of exchange funds
If the taxpayer or an agent receives the exchange funds or if the taxpayer is anyhow able to control the exchange funds during this period then it is violation of rule.
Use of a qualified intermediary
A qualified intermediary (QI) may be utilized to facilitate the 1031 exchange. A taxpayer cannot utilize their lawyer, accountant, Realtor, or a related party as a QI. Furthermore, several states require that QIs be agreeable with administrative requirements regarding bonding, insurance, and the manner in which exchange funds are held, state licensing, etc.