As you dive into the world of real estate investment, there are 1031 exchange rules you’ll need to familiarize yourself with. In doing so, you can gain more out of this cat and mouse game of investing and reinvesting, by legally deferring on capital gains taxes. The right way, of course.
Top 5 Rules You Should Remember
1. Exchange Of “Like-Kind” Properties
These two are the very words found in the IRS code, that only properties which fall under what’s deemed as “like-kind” will be eligible for 1031. And what the phrase implies isn’t really exactly as it sounds.
According to the Internal Revenue Services, it doesn’t refer to an exact “likeness” between properties to be exchanged. For instance, it is not limited to a 3-story business property being exchanged with another 3-story business property (although, something of this sort definitely counts under 1031).
Alternately, “like-kind” has more to do with the “purpose” of the properties. An example would be how a warehouse can be exchanged with a rental apartment. They are not alike in terms of structure but both are for business purposes.
Even an empty plot of land can be swapped for a rental home, granting that the first will be, or is, registered as a business estate.
Having said that, it’s also possible to exchange a rental home with another. However, there’s a separate clause for such properties, you’ll have to seek the assistance of a QI (Qualified Intermediary) to find out what the limitations are for this trade.
The same is true with seeking the aid of your QI in learning about what types of “purposes” are within the bounds of 1031 and which ones are not.
2. 3-Property Rule
Up to three properties can be bought for as long as you are able to close the deal for at least one of them. Though the federal government itself has set this as a regulation, most investors follow the 3-property rule also out of convenience. There are fewer documentation complexities when fewer properties involved in every combined portfolio.
In addition to this, experts tend to focus only on one of the three properties so that the 2nd and 3rd are merely considered as “secondary” or “back-up” dealings.
3. Fair Market Value Rule
Bear in mind that the 3-property rule has a cap. The aggregate Fair Market Value (or “total”) of all three must not go beyond 200% of the aggregate GSP (Gross Sale Price) of the surrendered properties which have been marketed and sold in your Exchange.
4. 45-Day Time Limit
This fixed duration, known as an Identification Period, is the timeframe that you (and your QI) are given, to identify the replacement property. And it should be completed in writing. This written identification of the potential replacement property is to be submitted to the 1031 office no later than 12:00 a.m. of the 45th day after the rights and ownership of the property itself have been transferred to the actual buyer.
The 45-day deadline includes weekends and holidays. There are no exceptions. We’d also like you to note that the IRS follows this timeframe to the dot, so be sure to observe it in the same manner.
5. 180-Day Time Limit
After the replacement property has been marked and chosen, you, as the investor, will have a fixed 180 days to officially close all transactions and process the rest of the mandatory documents and requirements.
Much like the 45-day time limit, the IRS also closely monitors this period very strictly.