1031 Exchange and 1031 Reverse Exchange
1031 Exchanges aka “Like-Kind or tax differed exchanges” are a tax provision that permits a taxpayer to defer and not pay income taxes on the gain on the sale of real estate investment property. This is provided the taxpayer reinvests the proceeds into similar, “like-kind” property within a certain period of time. The term “like-kind” in a real property transaction refers to the character of the structure, not the use or quality. There are several “rules” that the exchange runs off, if you follow the steps correctly you can save yourself quite a bit of capital gains taxes when the process is done.
A 1031 Exchange runs off a specific “timeline”. Day 0 is the beginning of the identification period. This begins on the day you close escrow on the property you will be exchanging. The 45 Day Rule allows the taxpayer 45 days from the time of sale of the relinquished property to search and find your new replacement property. This does not mean you have to close escrow on the property, you will be required to have a list of “like-kind” properties written down for approval in a document signed by a qualified intermediatory or have taken the title on the property already by the end of the time period. The party who serves in the role of this qualified intermediary cannot be someone with whom the seller has had a family relationship or business relationship during the previous two years. If a house is not chosen and approved by the end of this 45-day identification period, this will disqualify you from doing a 1031 Exchange. After this, comes the 180-day “Exchange Period” starts. During this time, you are required to invest your funds from the relinquished property into the chosen “like-kind” property. It is required that the sale is closed by the 180th day. In addition, the entire proceeds from the sale are to go towards the purchase of your new investment. If these steps are not followed, then you will not have the ability to defer your capital gains taxes.
3 Property Rule:
The 3 Property Rule states that the replacement property identification can be made for, “three properties without regard to the fair market values of the properties.”
This implements those the chosen replacement properties be no more than 200% above the relinquished properties value. This may work best for an investor exchanging for more than one smaller property rather than one property itself.
While using the 200% Rule it triggers the 95% Rule. This allows the investor to identify an unlimited amount of replacement properties on the condition that they acquire 95% combined value of the targeted properties within the 180-day exchange period.
Reverse 1031 Exchange:
A Reverse 1031 Exchange is another way for an investor to defer capital gains tax. The process is reversed as the relinquished property must be identified within 45 days of the purchase of the replacement property. The relinquished property then must be sold within 180 days of the newly acquired property purchase. You will need an exchange accommodations titleholder (EAT) to hold the title of the replacement property during the exchange. This outlines a Qualified Exchange Accommodation Agreement (QEAA) together for their “replacement property” and outlines the process of the exchange. A qualified intermediary will also need to be chosen to transfer the title of the relinquished property to the new buyer and the title of the replacement property to the investor. The Reverse Exchange requires the sale of the old property to be of equal or lesser value to the new property and “like-kind”.
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