What is a 1031 Exchange?
A 1031 exchange (IRS code section 1031) allows a real estate investor to sell a current investment property and then purchase a like-kind property in order to defer the payment of capital gains (or limit the amount of tax due). 1031 exchanges only apply to investment or business property, not personal residences. 1031 exchanges are permitted on residential property but they must be an investment property.
1031 Exchange Rule and Requirements
Using a Qualified Intermediary (third-party facilitator) – Investors must use a third-party qualified intermediary to facilitate the 1031 exchange. Any proceeds from the sale of relinquished property must be held by the qualified intermediary until they are transferred to the seller of the replacement property. The qualified intermediary must be an external party and have no other formal relationship with those exchanging the properties.
Like-Kind Property – The property being exchanged must be considered like-kind. Typically any type of real estate can be exchanged for any other type of real estate. A residential property can be exchanged for vacant land.
1031 Exchange Identification Rules
One of the following three guidelines must be utilized in order to define identification of the like-kind replacement properties:
- Three property rule – Identify three potential replacement properties with the intention of purchasing at least one.
- 200% rule – Identify more than three potential replacement properties as long as the aggregate value does not exceed 200% of the value of the relinquished property.
- 95% rule – Identify more than three potential replacement properties as long as properties are acquired which are valued at 95% of the market value of the identified properties.
1031 Exchange Time Frame
Beginning when the relinquished property has been closed, the 1031 exchangor has up to 45 days to identify potential replacement properties. The replacement property must be acquired within 180 days of when the relinquished property closed.
1031 Exchange Mortgage on Replacement Property
A 1031 exchange mortgage provides the real estate investor with financing to purchase a replacement property with a higher purchase price than the previous property that was sold. This allows the investor to reinvest the sale proceeds and defer capital gains taxes.
Reverse 1031 Exchange Financing
A reverse 1031 exchange allows the real estate investor to purchase their replacement property prior to selling their existing investment property. A reverse 1031 exchange lender provides the short-term loan until the the investor is able to sell the existing property and secure long-term financing for the new property.
1031 Exchange Loan Rules
A 1031 exchange requires the real estate investor to replace the value of the debt from the relinquished property that is sold. The value of the debt can be replaced with a combination of sources including a private money loan, seller-financing, traditional financing or cash.
The IRS will not allow the investor to be on title of the new property and old property at the same time. A reverse 1031 exchange requires the use of qualified intermediary to park or hold title of the new property until the previous property is sold.