<p>Section 1031 of the Internal Revenue Code allows an owner of business or investment real estate to sell old property (relinquished property) and acquire new property (replacement property) without paying any taxes on the profit of the sale of the old property. The principle underlying these “tax-deferred exchanges” is that by using the exchange value in one property to buy another—instead of receiving cash for that exchange value—a property owner is simply continuing the investment in the original property. As such, the IRS won’t recognize the sale as a taxable event, provided that the owner (referred to in this article as the “taxpayer” or “exchanger”) adheres to the many rules governing exchanges.</p>

<p>The purpose of this article is to provide an overview of some of the most fundamental 1031 exchange rules and concepts, as well as to clarify some common misconceptions. Each concept is discussed below.</p>

<h2>Calculating Taxes Due Upon Sale VS 1031 Exchange</h2>

<p>As a starting point, a taxpayer should always have a sense of his or her hypothetical tax liability before deciding whether to do an exchange. In very broad terms, the ultimate amount of tax is determined by “capital gain,” which is generally determined by subtracting the amount a taxpayer originally paid for a property from the amount which he or she sells it for. For instance, if Betty originally bought an apartment building in Omaha for $100,000 (her “cost basis”) and sells it for $250,000, her capital gain is $150,000. Betty may also add the value of any “capital improvements” she made during her ownership to her cost basis, which would reduce her recognized capital gain.</p>

<p>Betty’s $150,000 gain—provided it is long-term capital gain—is taxed at 15-20% depending on Betty’s income level. Betty probably also took a “depreciation” deduction over the period she owned the property, say, a total of $20,000. Depreciation is “recaptured” via a 25% tax upon sale. Betty’s gain could also be subject to state capital gain tax and/or depreciation recapture. Lastly, if Betty is a single person earning over $200,000 in the year of sale (or, for married couples filing jointly, earning over $250,000 in the year of sale), Betty would also be subject to the Net Investment Income Tax (“NIIT”) at the rate of 3.8%. The income pertaining to the sale of the property in addition to her other sources of income is included in determining whether Betty was subject to the NIIT. Some may be familiar with the NIIT by one of its nicknames: "Medicare" or "Obamacare Tax".</p>

<p>In this example, Betty’s (approximate) tax liability would be:<br />
&nbsp;</p>

<p>$22,500 in federal capital gain tax (15% of $150,000)</p>

<p>$5,000 in depreciation recapture (25% of $20,000)</p>

<p>$7,500 in state capital gain tax (5% of $150,000—actual amount varies by state)</p>

<p><span style="font-family:Calibri,sans-serif">$5,700 in NIIT tax ($5,700)</span></p>

<p>Total tax liability = $40,700 (Click for the <a aria-label="1031 Exchange Calculator" href="/calculators" title="1031 Exchange Calculator">1031 Exchange calculator</a>)<br />
&nbsp;</p>

<p>Note: Mortgage debt and the amount of Betty’s net cash proceeds after mortgage debt is paid off is <i>not </i>what determines capital gain.&nbsp;</p>

<h2>Taxes are Deferred, Not Eliminated with a 1031 Exchange</h2>

<p>If Betty decides she wants to reinvest the $40,700 she would otherwise pay in taxes into new real estate, she can <i>defer</i>, rather than eliminate, her capital gain, depreciation recapture, and other tax liability. But, if and when she eventually cashes out by selling the property she bought as replacement property, she will owe the $40,700 at that time, plus whatever additional tax liability accrued on the new property.</p>

<p>Exception: Upon the death of an exchanger, his or her heirs receive a “step up” in basis that <i>does </i>effectively eliminate the deferred taxes.&nbsp;</p>

<h2>Role of a Qualified Intermediary</h2>

<p>The most common kind of 1031 exchange is a “forward” or “delayed” exchange using a Qualified Intermediary, or QI, like Accruit. Rather than require an actual swap of one property—i.e., transferring relinquished property to Party A and also receiving replacement property from the same Party A—the forward exchange process effectively allows an exchanger to sell relinquished property to a third-party buyer and within 180 days thereafter acquire replacement property from a third-party seller, hence the “delayed” terminology.</p>

<p>The critical parts of this structure are that: (1) the QI is assigned the exchanger’s rights in both the relinquished and replacement property contracts, which allows the taxpayer to “exchange” properties with the QI, as required by Section 1031; and (2) the QI receives the net proceeds from the sale of relinquished property and uses them as directed by the taxpayer to acquire replacement property. If a taxpayer, or a disqualified person like a relative or agent, receives the funds, even briefly, the exchange won’t be valid.</p>

<p>Note: If replacement property must be acquired before relinquished property is sold—an increasingly common scenario in today’s tight real estate market—a “<a aria-label="Reverse 1031 Exchange" href="/blog/are-1031-reverse-tax-deferred-exchanges-real-estate-approved-irs" title="Reverse 1031 Exchange">reverse exchange</a>,” may be a possibility.</p>

<h2>1031 Exchange Timing Requirements</h2>

<p>Section 1031 has strict timing and identification requirements. If Betty elects to do an exchange, she must identify replacement property within 45 days after the date she closes the sale of her apartment building, and she has 180 days from the date of closing to ultimately acquire replacement property (135 days from the identification deadline).</p>

<p>With regard to identification, Betty may identify up to three potential replacement properties, and ultimately close on any one of them. If she wishes to identify more than three properties, she may do so provided that the combined fair market value of <i>all </i>identified properties does not exceed the 200% of the value of the relinquished property. In Betty’s example, the combined value of four or more identified properties could not be more than $500,000. If a taxpayer identifies more than three replacement properties and violates this “200% rule,” he or she must close on 95% of the value of all replacement properties, which in most circumstances means all of them. Read our article on <a aria-label="1031 Exchange Deadline Tips" href="/blog/1031-tips-deferred-like-kind-exchange-deadlines-%E2%80%93-basics" title="1031 Exchange Deadline Tips">Timing and identification</a> for more details.&nbsp;</p>

<h2>Like-Kind Property in a 1031 Exchange</h2>

<p>Relinquished property must be “like-kind” to replacement property. Despite the term “like-kind,” the two properties need not actually be of the same type or quality. In fact, all real estate is “like-kind” to all other real estate under Section 1031, provided that the exchanger has the intent to hold it for business or investment use (see below). Properties can also be exchanged across state lines. So, Betty could exchange her apartment building in Omaha for an office building in Tampa, a beachfront condo in Hawaii, or ranchland in Wyoming. Additionally, one property can be exchanged for multiple properties and vice versa.</p>

<p>Frequently, an exchanger wishes to acquire an interest in a multi-member LLC or other partnership that owns real estate as replacement property. However, interests in an entity are not like-kind and thus do <i>not </i>qualify for exchange treatment, even if it’s a special-purpose entity that only owns real estate. An exchanger may acquire a tenancy-in-common or other fractional interest in real estate, including an interest in a <a aria-label="DSTs" href="/blog/delaware-statutory-trusts-1031-exchange-investments" title="DSTs">Delaware Statutory Trust</a>,&nbsp;but the replacement property must be real estate, or another interest that qualifies as like-kind, like a leasehold interest longer than 30 years.</p>

<h2>Qualified Use and Holding Period</h2>

<p>As emphasized above, under Section 1031 a taxpayer must <i>intend </i>to hold<i> </i>both the relinquished and replacement properties for investment or use in a trade or business. Neither <a aria-label="1031 Exchange Rules for Vacation Homes" href="/blog/1031-exchange-rules-vacation-homes-primary-residences-and-mixed-use-properties" title="1031 Exchange Rules for Vacation Homes">vacation homes nor primary residences</a> qualify for 1031 exchange treatment, with some limited caveats. Holding vacant land for the appreciation in value, even if it generates no income, satisfies the rule, where, conversely, allowing a family member to “lease” property for less than fair-market-value rent may be problematic. A developer intending to “flip” property following development would not be eligible for 1031 treatment.</p>

<p>This holding period requirement raises the question of how long a taxpayer must hold property to qualify for 1031 treatment. The answer: it depends. While Section 1031 doesn’t specify a particular duration, time is relevant to determining intent. Two years is generally regarded as sufficient, and a shorter period of time could suffice if a taxpayer can demonstrate actual intent to hold the property at the time it was acquired. Perhaps an exchanger entered into a five-year commercial lease with a replacement property tenant shortly after acquiring the property, but because of quick appreciation in value receives an attractive cash offer after one year of ownership. Under such circumstances, the taxpayer may be excused for the relatively short holding period.</p>

<h2>Same Taxpayer Requirement</h2>

<p>The <i>taxpayer </i>who owns relinquished property must be the same taxpayer that acquires replacement property. The taxpayer may be an individual or entity and may not necessarily be the party on the deed. For instance, the taxpayer may own property in a living trust, an Illinois-type land trust, or a single-member LLC (“SMLLC”), all of which are generally “disregarded entities” for tax purposes, which means the entities don’t file their own tax returns but rather their assets are reported on the underlying taxpayer’s tax returns. Essentially, although they may provide important protection of personal assets or be effective estate planning strategies, the IRS treats them for tax purposes as if they don’t exist. So, if Betty owned her apartment building in Betty’s Investments, LLC, a SMLLC and thus disregarded entity, she could acquire replacement property in the same LLC, or a different SMLLC, or in her individual name, etc.&nbsp;</p>

<p>A <i>tax partnership</i>, however,<i> </i>is not a disregarded entity, it files its own tax returns and issues a K-1 to each partner/member and accordingly is a distinct tax entity. For example, if Betty and her sister Blanche owned the Omaha apartment building in a two-member LLC called BB Investments, LLC, <i>the LLC</i>—not Betty and Blanche as individuals—would be the taxpayer for exchange purposes. As such, BB Investments, LLC would have to acquire replacement property. If Betty and Blanche acquired it in their individual names, they would violate the same-taxpayer requirement and invalidate the exchange, unless they used a technique called “<a aria-label="1031 Exchange Drop and Swap" href="/blog/1031-drop-and-swap-out-partnership-or-llc" title="1031 Exchange Drop and Swap">drop and swap</a>." The drop and swap technique involves converting partnership interests to interests in the underlying real estate itself before an exchange.</p>

<h2>Avoiding “Boot” By Purchasing Replacement Property of Equal or Greater Value</h2>

<p>To fully defer taxes on all gain realized from the sale of relinquished property, an exchanger must acquire replacement property <i>of equal or greater value</i> to the relinquished property. This includes replacing any mortgage debt paid off at closing of the relinquished property with new mortgage debt on replacement property, or new cash. In other words, if Betty sells her apartment building for $250,000, she would have to acquire replacement property of at least $250,000, regardless of the amount of her net proceeds after debt payoff. If she paid off $100,000 in mortgage debt and only realized $150,000 in net proceeds, she would still have to acquire a $250,000 replacement property, and offset the $100,000 mortgage payoff with a new mortgage on her replacement property, or $100,000 of new cash. Cash received or debt paid off that is not offset by new debt or new cash is referred to as “cash boot” or “mortgage boot,” respectively.</p>

<p>Note: An exchanger <i>is</i> permitted to cash out a portion of the value of relinquished property, but would be taxed on that amount, starting with 25% depreciation recapture tax.</p>

<h2>Consult With a Knowledgeable QI</h2>

<p>As is apparent from the above discussion, successfully completing a 1031 exchange requires compliance with a number of rules. This article is a useful starting point to understand some of the most basic requirements, but is by no means exhaustive. We at <a>Accruit are</a>&nbsp;standing by to discuss your specific scenario and whether an exchange is advisable under your particular circumstances.</p>

<p>&nbsp;</p>

<h2>Christina’s First Investment</h2>

<p>After college, Christina chose to continue living with her parents, while she began saving for her future. In time, she had saved $20,000. With the aid of bank financing, Christina invested in her first rental property. She bought a modest 2-bedroom, 1½ bath condo near the local community college for $100,000. Over the time Christina owned the property, she had taken $25,000 in depreciation, paid $25,000 toward her initial mortgage, and her investment grew to $115,000. She decided that it was time to upgrade her investment.</p>

<p>After consulting with her tax and legal advisors, Christina learned that if she sold the condo outright, without the use of Section 1031, she would have to pay depreciation recapture taxes on the $25,000, as well as capital gains taxes on the $15,000.</p>

<p>$25,000 Depreciation</p>

<p class="tab">X 25% Federal Depreciation Recapture&nbsp; &nbsp; &nbsp; &nbsp; &nbsp;$6,250</p>

<p>X 5% State Depreciation Recapture&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;$1,250</p>

<p>+</p>

<p>$15,000 Capital Gains</p>

<p>X 15% Federal Capital Gains Tax&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;$2,250</p>

<p><u>X 5% State Capital Gains Tax&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; $750</u></p>

<p><strong>TOTAL TAX BITE&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; $10,500</strong></p>

<p>&nbsp;</p>

<p>Christina’s tax advisor showed her that she would lose approximately 2/3 of her investment gains to taxes if she were to sell the property outright. She had a good outcome with this initial investment and her tax advisor suggested that she structure the sale as part of a Section 1031 exchange, rather than an outright sale. Christina and her tax advisor crunched the numbers again, and learned:</p>

<p>Christina’s original investment&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;$20,000</p>

<p>Equity from mortgage payments made&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; $25,000</p>

<p><u>Equity from capital gains&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; $15,000</u></p>

<p><strong>TOTAL EQUITY AVAILABLE&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; $60,000</strong></p>

<p>&nbsp;</p>

<p>Christina agreed that a 1031 exchange was the best strategy for her, and she listed her modest condo for sale. Because it was well-maintained and near the community college, there were multiple offers. Christina promptly sought referrals from her tax and legal advisors, who both recommended the same Qualified Intermediary (QI). The QI worked closely with Christina’s advisors and the closing agent to prepare for the sale of her property. Christina was able to net $60,000 after all closing costs, and the closing agent sent this entire amount directly to Christina’s QI.</p>

<p>It is important to note that Christina must use all of her equity in the property – including her original $20,000 investment, the $25,000 paid off of the mortgage balance, and the $15,00 in capital gain – toward the purchase of her replacement property to defer all taxes. This is because if Christina had sought to withdraw her initial investment, the IRS would have characterized those funds as profit rather than the return of her original investment. This would have created a taxable event, which Christina was seeking to avoid.</p>

<p>Christina spent the next several weeks working with her real estate advisor, knowing that she had 45 days to provide her QI with a short list of potential replacement properties. Read this article for more information about the <a aria-label="1031 Exchange Rules and Regulations" href="/blog/what-are-rules-identification-and-receipt-replacement-property-irc-§1031-tax-deferred-exchange" title="1031 Exchange Rules and Regulations">identification rules</a>.</p>

<p>Working with her real estate advisor, Christina found a newer 3-bedroom, 2½ bath townhouse, with a garage, on a quiet street in a desirable neighborhood. Using the $60,000 from the sale of her first condo, Christina financed the remaining $240,000 needed to complete the acquisition of the $300,000 townhouse. Christina’s QI again collaborated with her advisors and the closing agent, and Christina was able to complete the acquisition of her second investment within the exchange period. Read for more information about <a aria-label="1031 Exchange Deadline Tips" href="/blog/1031-tips-deferred-like-kind-exchange-deadlines-–-basics" title="1031 Exchange Deadline Tips">exchange deadlines</a>.</p>

<h2>Consolidating Kelly’s Portfolio</h2>

<p>Like Christina, Kelly began investing in real estate right out of college. Over the years, Kelly has built a portfolio of six condos, townhouses, and single-family rentals in four towns near her home. But managing all of these properties was proving to be difficult and time consuming. Kelly wondered whether there was an easier way.</p>

<p>Kelly consulted with her tax and legal advisors, both of whom encouraged her to consider a Section 1031 exchange. Kelly’s portfolio is worth about $800,000, and if she were to sell outright, she would face about $275,000 in state and federal capital gains and depreciation recapture taxes. Kelly agreed that a 1031 exchange was the right way to go, and listed her properties with her local real estate agent. The listing indicated that they could be bought as a bundle, or individually.</p>

<p>Kelly also consulted with the QI that her advisors recommended. During the consultation, the QI pointed out that if she sold the various properties individually over a period of time, but still wanted to use the proceeds of all of them for one purchase, her identification and exchange periods would commence with the sale of the first property. The QI also pointed out that, depending on the timing of the sales, and the possibility that Kelly might want to acquire multiple replacement properties, Kelly could consider establishing multiple exchange accounts.</p>

<p>Fortunately, Kelly’s properties were all desirable, and her broker was able to secure one buyer for the entire portfolio. Kelly and her broker provided the sale contract to the QI, who prepared the necessary exchange documents. The QI worked closely with Kelly’s advisors and the closing agent to ensure that the net sale proceeds were sent directly to the QI rather than to Kelly or her attorney. At closing, the net proceeds of $700,000 (after expenses and paying off mortgage debt of just under $100,000) were sent to the QI, properly starting Kelly’s 1031 exchange.</p>

<p>Working with her real estate advisor, Kelly found a mixed-use, multi-tenant building near her home, consisting of two apartments, two stores, and three townhouses. Using the $700,000 in exchange proceeds, Kelly financed the remaining $900,000 needed to complete the acquisition of this property. (It is important to note that if Kelly wants the full benefits of a 1031 exchange, she would need to replace the debt paid off at the sale of her original property. Kelly obtained a new loan, but she also could have replaced the original debt with fresh cash. Further, Kelly is leveraging her equity to acquire a new property worth significantly more than the one she sold.) Kelly’s QI again worked closely with her advisors and the closing agent, and Kelly was able to complete the acquisition of her consolidated investment within the exchange period.</p>

<h2>Grandpa’s Estate Planning and Diversification</h2>

<p>Grandpa Al has owned a small shopping center for many years. He had no immediate need to sell the shopping center until he spoke with his new estate planning attorney. During the consultation with the estate planning attorney, Grandpa Al revealed that his Will provides that his four grandchildren will inherit the shopping center. The estate planning attorney pointed out that having four family members inherit one property was a recipe for a new family feud. He pointed out that the four grandchildren would likely have different ideas about what to do with the shopping center, and that he should consider restructuring his real estate investment. The estate planning attorney invited his tax attorney partner into the consultation, who educated Grandpa Al about 1031 exchanges.</p>

<p>Grandpa Al decided that he would sell the shopping center as part of a 1031 exchange. Working with his real estate advisor, Grandpa Al listed the shopping center for sale, and began looking for potential replacement properties.</p>

<p>Because the shopping center was well-maintained, and fully occupied, there were multiple offers. Grandpa Al promptly sought referrals from his tax and legal advisors for a QI. The QI worked closely with Grandpa Al’s advisors and the closing agent to prepare for the sale of the shopping center. Grandpa Al was able to net $1,000,000 after all closing costs, and the closing agent sent this entire amount directly to Grandpa Al’s QI.</p>

<p>Working with his real estate advisor, Grandpa Al found four identical condo units, within walking distance of the local university. Using the $1,000,000 in exchange proceeds, and some additional cash, Grandpa Al, completed the acquisition of the four condos for $1,100,000. Grandpa Al’s QI again worked closely with his advisors and the closing agent, and Grandpa Al was able to complete the acquisition of his newly diversified investment within the exchange period.</p>

<p>Grandpa Al then went back to his estate planning attorney to update his Will, so that each grandchild will inherit their own individual condo unit, and have the added benefit of a step-up in basis upon Grandpa Al’s death. This means that when Grandpa Al dies, his heirs will inherit the property at the fair market value as of the date of his death. Thus, there will be no depreciation recapture or capital gains to recognize.</p>

<p>Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.</p>

<p>As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property.</p>

<p>They say a picture is worth a thousand words. In this infographic, we've broken the 1031 exchange process into a series of simple steps:</p>

<drupal-media data-align="center" data-entity-type="media" data-entity-uuid="038b061d-b0d7-40dc-8eb9-cebcd9fdbdd7" data-view-mode="image_700w"></drupal-media>

<div style="margin-bottom:5px"><strong><a href="//www.slideshare.net/accruit/what-is-a-1031-exchange-infographic&quot; target="_blank" title="What is a 1031 exchange? Infographic">What is a 1031 exchange? Infographic</a> </strong> from <strong><a href="//www.slideshare.net/accruit&quot; target="_blank">Accruit</a></strong></div>

<div style="margin-bottom:5px">&nbsp;</div>

<div style="margin-bottom:5px"><em>Updated 3/03/2022.</em></div>

<h2>The Facts</h2>

<p>A qualified intermediary (QI) company, Accruit, received an inquiry from some taxpayers, who we will call Mr. and Mrs. Pike, regarding facilitating a real estate exchange.&nbsp; The clients got in touch with Accruit on July 14, 2014.</p>

<p>The Pikes had entered into a contract to sell their ½ interest in a multi-family investment property located in San Francisco, California.&nbsp; The contract called for a closing on August 15, 2014.&nbsp; The sale price was $1,000,000.&nbsp; At this point in time, the Pikes did not know what they might be acquiring as replacement property.&nbsp;</p>

<h2>The Problem</h2>

<p>They did not want to incur any tax in connection with the sale.&nbsp; Although QIs cannot give tax advice, and we did not, let’s assume their basis in the property being sold, the relinquished property, was $600,000 and their joint income was above $250,000 per year.&nbsp; The basis in property is determined by the original purchase price of the property plus the cost of any improvements they added to the property and minus any depreciation they took on the property during their period of ownership.&nbsp; Let’s assume they bought the property for $700,000, added $50,000 in improvements and took $150,000 in depreciation to arrive at the basis in the property.&nbsp; Without an exchange they would be looking at taxes as follows:</p>

<ul>
<li>20% capital gain on the appreciation ($250,000 x 20%)<img alt="Forward exchange of real estate" src="/sites/default/files/files/forward-exchange-example.jpg" style="width:83px; height:108px; float:right" /></li>
<li>25% recapture of depreciation taken ($150,000 x 25%)</li>
<li>Affordable Care Act tax ($250,000 x 3.8%)</li>
<li>Approximate effective rate of California capital gain ($250,000 x 9%)</li>
</ul>

<h2>The Solution: A 1031 Exchange</h2>

<p>A tax deferred exchange, in which the Pikes would trade up or even in value and have at least the same new mortgage liability as they had on the relinquished property, would negate the payment of any tax.&nbsp; The applicable forward exchange docs were prepared for the Pikes.&nbsp; They executed and returned these documents consisting of the following:</p>

<ul>
<li>Exchanger information form</li>
<li>Tax deferred exchange agreement</li>
<li>Qualified escrow agreement for the deposit and holding of the exchange funds</li>
<li>Assignment of rights in the relinquished property contract</li>
<li>Copy of the sale contract pertaining to the assignment</li>
<li>W-9 in connection with the interest to be earned on the deposit of the exchange funds</li>
<li>Copies of their drivers’ licenses</li>
</ul>

<p>For a non-1031 exchange transaction in California, the settlement agent may have to hold back some of the sale proceeds to cover the state’s capital gains liability.&nbsp; However when California taxpayers are selling relinquished property as the first step towards an exchange of property, the client will complete a form 593-C known as a “Real Estate Withholding Certificate” in order to obtain an exemption from the withholding.&nbsp; The QI is then responsible for withholding should the taxpayer not utilize all the funds in the exchange account when they acquire their replacement property.</p>

<p>The Pikes closed on the sale of their property on July 31, 2014, and the amount of $821,377 was wire transferred to their exchange account.&nbsp; Once the relinquished property sale was complete they needed to provide the following forms in order to complete their acquisition of the replacement property:</p>

<ul>
<li>Designation notice within 45 days of the sale identifying up to three potential replacement properties (<a href="/blog/1031-exchange-identification-replacement-rules">read more about the requirements for identifying replacement property</a>)</li>
<li>Assignment of rights in the replacement property contract</li>
<li>Copy of the purchase contract pertaining to the assignment</li>
<li>Disbursement instructions to the QI and the escrow agent for the replacement property purchase</li>
</ul>

<p>On August 26, 2014, the Pikes signed and returned the designation notice identifying a property in San Mateo, California as their only replacement property.&nbsp; On September 3, 2014, they assigned their rights under the replacement property contract and directed the QI to put down earnest money of $23,250 in connection with the purchase of the new property.&nbsp; On September 11, 2014, the QI was directed to wire transfer the additional sum of $776,414 to the settlement agent and the Pikes acquired the property at that time.</p>

<p>The client’s exchange account held an additional $21,176 of non-reinvested proceeds and the Pikes sought a return of that sum.&nbsp; Due to California’s withholding requirement, North Star completed a California Real Estate Withholding Tax Statement (Form 593) requiring a hold back and direct payment to the State of 3.33%, or $723. North Star remitted the balance to the Pikes.</p>

<p>The Pike’s will file an IRS form 8824 at the end of the tax year to report their exchange transaction.</p>

<h2>The Result</h2>

<p>With the exception of the small amount of tax pertaining to the funds not needed in the acquisition of the replacement property, the Pikes achieved tax deferral on the sale of their relinquished property&nbsp; - approximately a $112,000 savings which was reinvested in their replacement property.&nbsp;</p>

<p>Download the <a href="https://info.accruit.com/forward-exchange-whitepaper">1031 Forward Exchange Procedural Outline</a> of the step-by-step processes involved in completing a tax deferred exchange, which you may review with your tax advisor.</p>

<p>&nbsp;</p>

<p><em>Updated 2/24/2022.</em></p>

<p>Understanding the&nbsp;rules for identification in regards to a 1031 Exchange are essential for ensuring you&nbsp;are on track for a valid 1031 Exchange. The rules were established as part of the Tax Reform Act of 1984 and have remained unchanged to date. Let's review the article below which covers the specific rules for identification, as well as receipt of replacement property.</p>

<h2>Why is it Necessary to Identify Replacement Property?</h2>

<p>In a typical Internal Revenue Code (IRC) §1031 delayed exchange, commonly known as a <a href="/services/1031-exchange">1031 exchange</a> or tax deferred exchange, a taxpayer has 45 days from the date of sale of the relinquished property to identify potential replacement property.&nbsp; This 45-day window is known as the identification period.&nbsp; The taxpayer has 180 days (shorter in some circumstances) to acquire one or more of the identified properties, which is known as the exchange period. Property(ies) actually acquired within the 45-day identification period do not have to be specifically identified, however they do count toward the 3-property and 200 percent rules discussed below.</p>

<p>These rules are a direct result of the Starker case where for the first time a taxpayer was found to be able to sell relinquished property on one day and acquire replacement property at a different point in time.&nbsp; In fact, the Starker case involved a five-year gap between the sale and purchase.&nbsp; Prior to the decision in the Starker case, it was believed that an exchange had to be simultaneous.&nbsp; As a result of the open-endedness of this decision, as part of the Tax Reform Act of 1984, Congress added the 45/180 day limitation to the delayed exchange.&nbsp; These time limitations were a compromise between allowing an exchange to be non-simultaneous while at the same time having some temporal continuity between the sale and the purchase.</p>

<h2>What are the Identification and Receipt Rules?</h2>

<p>The identification rules in a 1031 exchange include the following:</p>

<ul>
<li>The 45-day requirement to designate replacement property</li>
<li>The 3-property rule</li>
<li>The 200-percent rule</li>
<li>The 95-percent rule</li>
<li>The incidental property rule</li>
<li>Description of Replacement Property</li>
<li>Property to be produced</li>
</ul>

<h2><strong>The 45-day Identification Rule</strong></h2>

<p>The exchange regulations provide “The identification period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the 45th day thereafter.”&nbsp; The identification must (i) appear in a written document, (ii) signed by the taxpayer and (iii) be delivered to the replacement property seller or any other person that is not a disqualified person who is involved in the exchange.&nbsp; The custom and practice is for the identification to be delivered to the qualified intermediary, however a written statement in a contract to purchase the replacement property stating that the buyer is identifying the subject property as his replacement would meet the requirements of the identification.&nbsp; The restriction against providing the notice to a disqualified person is that such a person may be likely to bend the rules a bit based upon the person’s close relation to the taxpayer.&nbsp; Disqualified persons generally are those who have an agency relationship with the taxpayer.&nbsp; They include the taxpayer’s employee, attorney, accountant, investment banker and real estate agent if any of those parties provided services during the two-year period prior to the transfer of the relinquished property.&nbsp; Property identifications made within the 45-day period can be revoked and replaced with new identifications, but only if done so within that the identification period.</p>

<h2><strong>The 3-Property Rule</strong></h2>

<p>This rule simply states that the replacement property identification can be made for up to “three properties without regard to the fair market values of the properties.”&nbsp; At one time in the history of §1031 exchanges, there was a requirement to prioritize identified properties.&nbsp; At those times, if a taxpayer wished to acquire a second identified property, they could not do so unless the first identified property fell through due to circumstances beyond the taxpayer’s control.&nbsp;&nbsp; Presumably this harsh requirement played a role in the 1991 Treasury Regulations where the 3-Property Rule is found.&nbsp; By far and away, most taxpayers utilize this rule.</p>

<h2><strong>The 200% Percent Rule</strong></h2>

<p>The 200-percent rule states the taxpayer may identify:&nbsp;</p>

<blockquote>
<p>“Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer.”&nbsp;</p>
</blockquote>

<p>Another way to state this is that the taxpayer can identify any number of properties and actually close on any number of them if the sum of the market value of all of them does not exceed twice the market value of the relinquished property.&nbsp; There is some uncertainty of how the market value of these properties is determined.&nbsp; The listing price? The amount the seller is willing to accept?&nbsp; The amount that the taxpayer agrees to pay?&nbsp; The answer is unclear but using the listing price would surely be a safe choice.</p>

<h2><strong>The 95% Rule</strong></h2>

<p>The 95-percent rule is defined as follows:&nbsp;</p>

<blockquote>
<p>“Any replacement property identified before the end of the identification period and received before the end of the exchange period, but only if the taxpayer receives before the end of the exchange period identified replacement property the fair market value of which is at least 95 percent of the aggregate fair market value of all identified replacement properties."</p>
</blockquote>

<p>As a practical matter, this rule is very hard to adhere to.&nbsp; Basically, it provides that should the taxpayer have over identified for purpose of the first two rules, the identification can still be considered valid if the taxpayer receives at least 95% in value of what was identified.&nbsp; For example, if a taxpayer identified four properties or more whose market value exceeds 200% of the value of the relinquished property, to the extent that the taxpayer received 95% of what was “over” identified then the identification is deemed proper.&nbsp; In the real world it is difficult to imagine this rule being relied upon by a taxpayer.</p>

<h2><strong>The Incidental Property Rule in Section 1031</strong></h2>

<p>The incidental property rule is defined as follows:&nbsp;</p>

<blockquote>
<p>“Solely for purposes of applying this paragraph (c), property that is incidental to a larger item of property is not treated as property that is separate from the larger item of property. Property is incidental to a larger item of property if - (A) In standard commercial transactions, the property is typically transferred together with the larger item of property, and (B) The aggregate fair market value of all of the incidental property does not exceed 15 percent of the aggregate fair market value of the larger item of property.”&nbsp;</p>
</blockquote>

<p style="text-align:center"><img alt="Incidental Property" height="526" src="/sites/default/files/files/incideental-property.jpg" width="800" /></p>

<p>In other words, if there is some incidental property that typically passes to a buyer in standard commercial transactions for this kind of property sale, to the extent that the value of any such property is less than 15%&nbsp; of the primary property, the incidental property does not have to be separately identified.</p>

<p>To illustrate this rule the exchange regulations use the example of an apartment building to be acquired for $1,000,000 which includes furniture, laundry machines and other miscellaneous items of personal property whose aggregate value does not exceed $150,000.&nbsp; In this example, those various items of personal property are not required to be separately identified nor does that property count against the 3-Property Rule.&nbsp; Be aware however that this rule only applies to identification and not to making sure that replacement property must still be like-kind to the relinquished property.&nbsp; For example, if the relinquished property was real estate with a value of $1,000,000 and the replacement property was real estate with a value of $850,000 plus incidental property of $150,000, the taxpayer will still have tax to pay (known as “ boot”) because the incidental personal property was not like-kind to the relinquished property.</p>

<h2><strong>Description of Replacement Property in IRS 1031 Exchange</strong></h2>

<p>The description of replacement property must be unambiguous and specific.&nbsp; For instance, the identification of “a condominium unit at 123 Main Street, Chicago, IL” would fail due to the specific unit not having been identified.&nbsp; The actual rules are as follows:</p>

<ul>
<li>Replacement property is identified only if it is unambiguously described in the written document or agreement.</li>
<li>Real property generally is unambiguously described if it is described by a legal description, street address, or distinguishable name (e.g., the Mayfair Apartment Building).</li>
<li>Personal property generally is unambiguously described if it is described by a specific description of the particular type of property. For example, a truck generally is unambiguously described if it is described by a specific make and model.</li>
</ul>

<h2><strong>1031 Exchange Property to Be Improved or Produced</strong></h2>

<p>Oftentimes, the property intended to be acquired by the taxpayer will be in a different physical state at the time it is identified than it will be upon receipt by the taxpayer.&nbsp; The regulations account for this by requiring the identification for real estate to include the address or legal description of the property plus&nbsp;as much detail as practical about the intended improvements.&nbsp; In connection with the receipt of property to be improved, even if the described improvements are not completed at the time it is received by&nbsp;the taxpayer,&nbsp;the exchange is valid so long as the actual property received does not differ from&nbsp;what was identified by the taxpayer&nbsp;except for the degree of improvements that have been completed. Personal property is a bit different in this regard and the “production” (improvements) needs to be completed within the 180-day term.</p>

<h2>Summary</h2>

<p>The ability to defer taxes through a §1031 exchange is a very valuable benefit to taxpayers.&nbsp; However, to receive this benefit, all the exchange rules must be strictly adhered to.&nbsp; The rules pertaining to identification and receipt of replacement property must be understood and met in order to comply with the technical requirements of this IRC section.&nbsp; In fact, the property identification rules are so germane to a proper exchange that there is a question asked of the taxpayer on the exchange reporting form 8824 about compliance with these rules.</p>

<p>&nbsp;</p>
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<p><em>Updated 2/23/2022.</em></p>

<p>It's been a number of years since we visited this article and while the core of 1031 exchanges have not changed, it is important to remember the foundation to ensure compliance. Two separate deadlines drive the 1031 exchange process and they are covered at length below. Another important concept discussed is how the 180-day exchange period which can be affected by the due date of the taxpayers return, so be sure to take special consideration of that&nbsp;as you read through the article below.&nbsp;</p>

<p>Despite working with <a href="/sites/default/files/FAQs.pdf" target="_blank">like-kind exchanges</a> (LKEs) for a number of years, we never tire of discussing the basics. That’s because, despite structural intricacies, LKEs are, at their core, deadline and document driven. It’s these basics that build a strong foundation for understanding LKEs as they increase in complexity. For this month’s LKE tip, let’s consider some basics and focus on exchange deadlines.</p>

<p>LKEs generally consist of two separate deadlines:</p>

<ul>
<li>The 45-Day Identification Deadline and</li>
<li>the 180-Day Completion Deadline.</li>
</ul>

<p>The 45-day window is frequently referred to as the “identification period,” while the 180-day window is often called the “exchange period.” Note that both deadlines are triggered on the same date and run concurrently.</p>

<p>In a standard Delayed Exchange (taxpayer sells first and buys at a later date), both deadlines are triggered on the date ownership of the relinquished property is transferred. Under the standard Reverse Exchange structure (buy first, sell later), both deadlines are triggered on the initial ownership transfer date of the replacement property. However, for both types, the counting of days doesn’t actually begin until the day after ownership transfer occurs.</p>

<p>In order to complete a valid 1031 exchange, the replacement property must be both:</p>

<ul>
<li>properly identified by midnight on day 45 and</li>
<li>received by midnight on day 180.</li>
</ul>

<p>A couple other things to note:</p>

<ul>
<li>Both the 45- and 180-day deadlines include all calendar days, including weekends and holidays.</li>
<li>The deadlines are absolute with extensions only allowed for:
<ul>
<li>Presidentially declared disasters</li>
<li>Terrorist or military actions</li>
<li>Taxpayers serving in combat zones</li>
</ul>
</li>
</ul>

<ul>
</ul>

<p>Furthermore, as we approach the end of the calendar tax year, it is vital to fully understand the 180-day deadline. The regulations clearly specify the exchange period as:</p>

<blockquote>
<p>“..the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) of the taxpayer’s return of the tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”</p>
</blockquote>

<p>In short, if you are participating in a like-kind exchange, be sure to review the due date of your tax return and contemplate the need to apply for an extension of time to file. Otherwise, you might find yourself with an unexpectedly short exchange period.</p>

<p>&nbsp;</p>

<p><em>Updated 2.07.2022.</em></p>