10 Key Questions to Ask Before Starting a 1031 Exchange

If you are looking to sell real property that was held for investment or business use, you may be interested in learning how you could defer capital gains, depreciation recapture, and new investment income tax on the transaction through a 1031 Exchange. If you are considering a 1031 Exchange, below are ten great questions to ask to gain a general knowledge of the 1031 Exchange process.

What is a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange, is a tax-deferred transaction that allows a real estate investor to sell qualifying property and reinvest the proceeds into other qualifying property without immediately paying capital gains taxes.

What are the main eligibility requirements for a 1031 Exchange?

To be eligible for a 1031 exchange, both the Relinquished Property (the property being sold) and the Replacement Property (the property being acquired) must be held for productive use in a trade or business or as an investment. Additionally, the properties must be of like-kind. Generally, all business or investment property is like-kind to one another, regardless of use or character. Further, the taxpayer that sells Relinquished Property must be the one taking ownership to Replacement Property; this is known as the Same Taxpayer Rule.

What types of properties qualify for a 1031 Exchange?

Any real estate property held for productive use in a trade or business or as an investment can qualify for a 1031 exchange. This includes residential rental properties, commercial properties, land, and even vacation homes if they adhere to the specific regulations on personal use time frames.

What are the time constraints for completing a 1031 Exchange?

The IRS imposes strict time constraints for completing a 1031 exchange. Once the Relinquished Property is sold, the investor has 45 calendar days to identify potential Replacement Properties and 180 calendar days to close on the purchase of one or more of those identified Replacement Properties.

What is the process for identifying Replacement Properties in a 1031 Exchange?

The investor must follow certain identification rules when identifying Replacement Property(ies). The three identification rules include: the 3-property rule (identifying up to three properties of any value); the 200% rule (identifying any number of properties as long as the total value of those properties does not exceed 200% of the value of the relinquished property); or if the taxpayer violates both of those rules, then the taxpayer needs to acquire 95% of the value of all identified properties in order to complete their 1031 exchange – 95% rule.

Can I use a Qualified Intermediary for a 1031 Exchange?

Yes, a Qualified Intermediary (QI) is typically used to facilitate a 1031 Exchange. The Qualified Intermediary (QI) is a third-party facilitator that through a series of assignments acts as the party to complete the exchange with the Exchanger. Failure to use a QI can result in missteps, causing the disqualification of the exchange and the loss of tax deferral benefits.

How does the tax deferral work in a 1031 Exchange?

In a 1031 Exchange, the capital gains taxes that would normally be owed on the sale of the Relinquished Property are deferred until the Replacement Property is sold without the use of a 1031 Exchange. If the investor continues to use 1031 Exchanges for subsequent property sales, the taxes can be deferred indefinitely.

What happens if I receive cash or other non-like-kind property in a 1031 Exchange?

If the investor receives any cash or other non-like-kind property as part of the exchange, that portion of the transaction is referred to as “boot” and would be subject to capital gains taxes.

Are there any risks associated with a 1031 Exchange?

There are risks associated with not being able to complete a valid 1031 exchange. First is the possibility that the investor may not be able to find a suitable Replacement Property within the required timeframe. Another is that the closing on the Replacement Property purchase won’t occur within the 180-day exchange period. Additionally, there remains the possibility that the investor could identify qualifying replacement property, but then not be able to negotiate the purchase of that property. It is always suggested to consult with your Legal or Tax Advisor before starting a 1031 exchange.

What are the potential benefits of a 1031 Exchange?

The potential benefits of a 1031 exchange include the ability to defer capital gains tax, depreciation recapture tax, and net investment income tax, allowing the investor to reinvest more money into a new property. Additionally, 1031 exchanges can be used to consolidate properties, diversify a real estate portfolio, relocate to a different market, or as part of an estate plan.

Does a 1031 Exchange still sound like a fit for you and your real estate transaction? Reach to our 1031 Exchange team to get the process started today!