What You Should Know About 1031 Exchanges  

Three rules for identifying replacement properties for a 1031 tax exchange revealed.

September 20, 2007
by Jerry McCarthy, CPA/PFS

As many CPAs are aware, a 1031 exchange is recognized as a powerful tool for investors to keep more appreciation in their investment properties by deferring capital gains taxes (see related story in today’s issue) Considering that the value of a 1031 exchange may represent a significant portion of an investor's net worth and retirement, all steps taken and decisions made are critical to a successful exchange.

A 1031 exchange is an exchange of property in which capital gains tax deferral is available to real estate owners who sell their investment, rental, or business real estate, and reinvest the proceeds in qualified replacement properties. The replacement property must be similar in nature (to be used for investment, rental or business) and therefore considered “like-kind.” Examples of “like-kind” property include rental homes and condominiums, apartment buildings, shopping centers, office buildings and raw or unimproved land. Some examples where property is not considered “like-kind” are bonds, securities, real estate investment trust (REIT) stock, interests in partnerships and property outside the United States.

Virtually anyone who owns real estate investments should be educated on the benefits of how a 1031 exchange works. Specifically, individuals with highly appreciated real estate may find this strategy beneficial in controlling the current and future tax exposure. With investors who have a significant portion of net worth in real estate, this can be a way to seek further diversification of their overall net worth.

Property owners may sell and replace like-kind properties and defer taxes on the profits by meeting the requirements of Internal Revenue Code (IRC) for 1031 exchange properties. IRC 1031 states: “No gain or loss shall be recognized in a trade, business or for investment purposes if such property is exchanged solely for property of like-kind, which is to be held for productive use in trade or business or for investment purposes.”

The critical aspect where many investors nullify a valid exchange is the time frame for exchanges. Sellers of 1031 exchange properties have a maximum of 180 calendar days from the closing of the initial sale of the relinquished property to complete the exchange into their replacement properties. Within the first 45 days after close a seller must designate replacement properties and properly identify them in compliance with IRS regulations. This most frequently is done by using a Qualified Intermediary, also known as an Exchange Accommodator.

The IRS requires that non-simultaneous 1031 Exchanges use an independent, unrelated Qualified Intermediary. The Qualified Intermediary acts as the middleman for the purpose of acquiring and transferring the relinquished and replacement properties to create the exchange. The Intermediary can provide the appropriate language for contracts along with instructions to attorneys for closing both the relinquished and replacement properties. They also must be an independent, unrelated third-party and will secure funds held in an interest-bearing escrow account until the transactions are completed.

Three Rules for Identifying Replacement Properties for 1031 Tax Exchange

There are three rules for identifying replacement properties for a 1031 tax exchange. The most common is the three property rule which states that a seller may identify up to three replacement properties regardless of their value. The second rule is that a seller may identify any number of replacement properties but the combined value may not exceed 200 percent of the value of the initial property sale. The third rule for identifying replacement properties is any number of properties of any value may be identified as long as the final value of the properties exchanged into is equal to 95 percent of all of the replacement properties identified. The funds in a trust account with the Qualified Intermediary can be used as deposit or earnest money in the purchase of the designated replacement property once all IRS requirements for a 1031 exchange are met.

If no new properties are identified in the first 45 days and no designated transaction is completed during the full 180-day period, the funds in the trust account will be liquidated and the sale proceeds taxed at the prevailing state and federal capital gains and depreciation recapture taxes.

Many investors don't take advantage of 1031 exchanges because of the fear of the 45-day identification period. This fear is supported by numerous horror stories of failed exchanges and the resulting devastating taxes that can result from such failures.

With proper planning and the right resources investors can navigate the waters of a 1031 exchange and frequently double or triple their investment income while diversifying their portfolio thus reducing risk. Key requirements are a good grasp of the exchange process, a clear set of investment objectives and a plentiful and consistent source of quality replacement properties.

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Jeremiah F. McCarthy, CPA/PFS, CFP, specializes in: personal financial planning; wealth management including: asset allocation and portfolio management; retirement and estate planning; and tax preparation and planning. McCarthy is a member of both the AICPA and Ohio Society of CPAs. He founded a fee-only , Registered Investment Advisory firm and is the founder of McCarthy Tax Services, LLC and Wealth Advisors, LLC.