If you are considering selling your investment property, remember that the IRS will tax your capital gains at 15% and then California will take an additional 9.3% for a grand total of 24.3% in taxes on your hard-earned equity. If you would like to defer that painful tax bill, you may want to consider doing a 1031 Exchange. What is a 1031 Exchange you may ask? A 1031 Exchange allows investors to ‘exchange’ ‘like-kind’ properties rather than sell them through the use of a Qualified Intermediary who holds the sale proceeds from the first property until a replacement property(ies) can be purchased within a very specific, non-extendable time period. Let us walk through the salient points of this description one-by-one so that we can get a better understanding of the 1031 Exchange requirements.
A transaction is considered an exchange rather than a simple sale when the seller expects to acquire a replacement ‘like kind’ property. That means that if you are selling an investment property, you must state that you plan to acquire replacement investment property(ies) within a specific time frame. A special note, acquiring investment property outside of the United States in exchange for investment property within the United States is not considered ‘like-kind.’
When you acquire the replacement property(ies), you must roll all the net proceeds from the first property into the replacement property(ies) or you will be taxed on the unused proceeds. Additionally, the value, equity, and debt on the replacement property(ies) must be equal to or greater than the value, equity, and debt on the relinquished property.
You may choose one or more replacement properties to replace your relinquished property though you do need to satisfy one of the following requirements:
- Three-Property Rule - Up to three potential replacement properties may be identified regardless of their value.
- The 200% Rule – Any number of properties may be identified as replacement properties as long as their value does not exceed twice the value (200%) of the relinquished property.
- The 95% Rule – The taxpayer may identify any number of properties for exchange but you must acquire 95% of the aggregate Fair Market Value (FMV) of all identified properties by the end of the exchange period. Put another way, in order for the exchange to be valid, 95% (or all) of the identified properties must be purchased.
The timeline (wiki link) for a 1031 Exchange is very specific and does not afford anyone room for error. Firstly, you must identify the property for exchange in writing, signed by you , and delivered to an independent party, i.e. a Qualified Intermediary, prior to the closing of said property. After closing, the countdown begins. First, you enter the Identification Period in which you have 45 days to identify the replacement property(ies). Secondly, you must acquire the replacement property(ies) within 180 days of closing commonly referred to as the Replacement Period. One must note that the Identification Period and Replacement Period overlap and both begin with the closing of the relinquished property. These two time periods must be strictly adhered to and are not extendable even if the 45th or 180th day falls on a weekend or holiday.
To facilitate the exchange transaction (wiki link), a Qualified Intermediary (QI) must be used. Your relationship with the QI generally begins when you identify the property for exchange. Of course, there are several rules by which you must abide when choosing a QI. The QI may not be related to you or have had a financial relationship during the two years preceding the property exchange. In other words, your current attorney, CPA or real estate agent may not act as your QI.
The Qualified Intermediary preforms three functions during the exchange. They acquire the relinquished property and transfer ownership to the buyer. The QI then holds the sale proceeds , thereby preventing you from having actually realized any funds from the sale of the relinquished property. The QI then acquires the replacement property(ies) and transfers it to you within the time limits to complete the exchange.
Interestingly enough, there are some situations where you can combine the 1031 Exchange with the Internal Revenue Code Section 121, which allows a married couple to exclude up to $500,000 of gain on the sale of their personal residence. In order to use both the 1031 Exchange and Section 121 in tandem, you must comply with all the rules in both sections, with Section 121 regulations applied to gain before applying the 1031 Exchange regulations. Revenue Procedure 2005-14 explains how the two statutes may be combined for one property.
As with any tax legislation, there are numerous rules and regulations that you must follow – more than I can possibly cover well in this article. I strongly recommend that you consult a tax attorney or CPA before deciding to embark upon a 1031 Exchange or a Section121/1031 Exchange combination. For more information on 1031 Exchange, please visit www.1031.org.