There are very specific requirements that you must follow so that your sale transaction will qualify for 1031 Tax Deferred Exchange treatment under Section 1031 of the Internal Revenue Code (tax code).You should always consult with your legal, tax and financial advisors to determine which tax deferral or tax exclusion strategy is the most suitable for your specific circumstances. The Q&A below is only a brief summary to assist you in understanding the very basic 1031 Exchange rules and requirements.

What Is a 1031 Tax Deferred Exchange?

The 1031 Exchange allows you to sell one or more appreciated assets that are generally rental or investment real estate and defer the payment of your capital gain taxes by acquiring one or more replacement properties.

How do I calculate the capital gain taxes owed?

There are three steps involved in determining the capital gain taxes that are owed. The first is to determine the net adjusted basis – this is calculated by starting with the original purchase price, adding the capital improvements and subtracting the depreciation taken. The second step is calculating the actual capital gain by taking today’s sales price, subtracting the net adjusted basis and then subtracting the cost of sale to arrive at the capital gain. The third, and final step, is determining the capital gain owed. Under this formula, the recaptured depreciation is all taxed at 25% and the remaining economic gain is taxed at the maximum capital gain tax rate which is currently 15%. Finally, the state tax rate, when applicable, is also applied to the capital gain. All three of these amounts, the depreciation recapture, the federal amount and the state tax, are added to arrive at the total capital gain tax due.

Are there time restrictions on a 1031 Exchange transaction?

Yes, there is a 180-day time span in which the 1031 Exchange must take place. During this period, there is also a 45-day period where the taxpayer must identify which replacement property will be purchased.

How can I defer the maximum amount of capital gains tax in a 1031 Exchange?

The replacement property being purchased must be equal or greater in value to the relinquished property being sold. The entire net proceeds from the sale must be used to purchase the replacement property.

What is “boot”?

Boot is any non like-kind property received by the exchanger and is taxable to the extent there is capital gain. “Cash boot” is the receipt of exchange proceeds by the exchanger. “Mortgage boot”, also sometimes referred to as “debt relief,” is the exchanger having less debt on the replacement property or properties that they had on their relinquished property. Cash or mortgage boot can be offset by the exchanger adding outside cash to the replacement property purchase. If the exchanger wants to receive cash boot, it must be received either at the closing of the relinquished property or after they have purchased all property they are entitled to under the exchange agreement- which is generally the end of the exchange period.

What types of property can be exchanged and what is the definition of like-kind property?

Any property held for productive use of trade or business or for investment can be exchanged for any other property held for productive use in trade or business or for investment – these properties are considered “like-kind” to one another. Examples of like-kind investment real estate include: exchanging unimproved for improved property; a fee interest for a leasehold with 30 or more years left; exchanging vacant raw land for a commercial building; or exchanging a single family rental for a small apartment complex. The rules for exchanges of personal property are significantly more narrow and class or asset code specific than for real property.

Can I use my primary residence or second home for a 1031 Exchange?

No, only real estate property held for business or investment purposes can be used in a 1031 exchange, and both properties in the transaction must be of “like kind.”

Can I sell or buy multiple properties in a 1031 Exchange?

Yes, you can exchange multiple smaller properties for a larger one and vice versa. The key is always trade up in value in order to maximize the amount of capital gains taxes that are deferred.

What is a Qualified Intermediary and do I have to use one in a 1031 Exchange?

The Qualified Intermediary (QI), also called an accommodator, is a third party that facilitates the transaction and is required by the IRS to qualify a 1031 tax exchange. The IRS does not allow your accountant, attorney, or escrow company to act as the QI. Yes, you can exchange multiple smaller properties for a larger one and vice versa. The key is always trade up in value in order to maximize the amount of capital gains taxes that are deferred.

What are the 1031 Exchange Identification Requirements?

You must identify your potential like-kind replacement properties to your Qualified Intermediary within the 1031 Exchange time limits discussed above. The identification must comply with one of the like-kind replacement property identification rules outlined below:

Three (3) Property Identification Rule

The three (3) property identification rule is the most common rule and is used in most 1031 Exchange transactions. This rule allows you to identify up to but not more than three (3) potential like-kind replacement properties. It is highly advisable that you identify three (3) properties even if your intent is to only acquire one.
If you are looking to diversify your investment real estate portfolio and needs to identify more than three potential like-kind replacement properties one of the following two rules should be considered.

200% of Fair Market Value Identification Rule

The 200% of fair market value rule allows you to identify more than three (3) potential like-kind replacement properties as long as the total fair market value of all the potential like-kind replacement properties identified does not exceed 200% of the sales price of the relinquished property(ies).

95% Exception to Identification Rules

The 95% exception to the identification rules allows you to identify as many like-kind replacement properties as you wish provided you actually acquire and close on 95% of the fair market value actually identified.