Guidelines for Section 1031 Exchanges

Provided by Jim Livesey,

BEACON EXCHANGE COMPANY LLC 

Background

Section 1031 of the Internal Revenue Code enables property owners who are selling “business or investment property,” such as rental residential property, to indefinitely defer capital gains tax.  To consider a Section 1031 Exchange, the property owner must initially meet these two guidelines:

 1.    The property that the owner is selling must qualify as “business or investment property.”  This includes land, rental, multi-family, and commercial/industrial buildings; and

 2.    The property owner must acquire a qualifying “Replacement Property,” such as another rental, multi-family, commercial/industrial property, or land.

Property owners who meet these two broad qualifications should look into the benefits of a Section 1031 Exchange when arranging for the sale and purchase of their properties.

What is a Section 1031 Exchange

A Section 1031 Exchange, often referred to as a “like-kind” exchange, rarely involves two people trading properties.  It almost always involves a property owner:

·       working with his or her broker who will assist in selling one property, such as land or a commercial/rental property, then purchasing another “business or investment” property; and

·       working with a Qualified Intermediary, such as Chicago Deferred Exchange Corporation (“CDEC”), who will provide the documents, depository services, and guidance necessary for the property owner’s sale and purchase to qualify as an “exchange” for tax purposes.

 Please note:

·       Although Section 1031 Exchanges most often consist of the sale of one property and the purchase of another, it is possible for exchanges to include multiple properties.  For example, a property owner may sell one property and acquire two, or sell three properties and acquire one, using all of the proceeds from the sale of the relinquished proceeds while completing a Section 1031 Exchange.

·       Different types of property can be exchanged.  For example:  a property owner can sell land and buy a residential rental property, or sell residential rental property and buy a commercial property, or sell commercial property and buy an industrial or residential rental property. 

·       The sold, or “Relinquished Property” and the purchased, or “Replacement Property,” need not be of the same value; however, the purchase of a Replacement Property for an amount less than the sale price of the Relinquished Property may give rise to a limited capital gains tax.  

Types of Exchanges

Forward (or Delayed) Exchange:  This type of exchange occurs when the Relinquished Property is first sold, then the Replacement Property is acquired at a later date.  This is the most common and generally the simplest and least expensive type of exchange.  Please see the important time constraints noted below.

Reverse Exchange (Parking Arrangement):  This type of exchange occurs when the property owner desires to, or must, acquire the Replacement Property before selling the Relinquished Property.  Reverse Exchanges are generally more complex and involve a larger role for the Qualified Intermediary than a Forward Exchange.

Construction or “Build-to-Suit” Exchange:  This type of exchange involves Replacement Property that must be constructed or undergo extensive renovations before it can be acquired by the property owner to complete his or her exchange.  These exchanges also involve a fairly substantial role for the Qualified Intermediary.

Forward Exchange Guidelines

1.    Both the Relinquished Property and the Replacement Property must be “used in a trade or business or held for investment.”  Commercial property, land, residential rental property, including single and multi-family homes, condos, and apartment buildings all will generally qualify. 

2.    Please note two very important deadlines: 

a.     unless the property owner has acquired his or her Replacement Property within 45 days of the sale of the Relinquished Property, the owner must identify potential replacement properties, in writing, to the Qualified Intermediary by the 45^th day following the sale of the Relinquished Property; and  

b.     the Replacement Property must be purchased within 180 days of the closing of the Relinquished Property.

3.    When identifying potential Replacement Property to the Qualified Intermediary in a Section 1031 Exchange, the property owner has these three options:

a.     The Three Property Rule (most common):  Any three properties regardless of their market value; or

b.     The 200% Rule:  Any number of properties provided that their aggregate value does not exceed 200% of the sale price of the Relinquished Property;

c.     The 95% Rule (not common):  The value of the Replacement Properties acquired must represent at least 95% of the value of the Replacement Properties identified.

4.  The property owner is not required to purchase all of the designated Replacement Properties, but must ultimately acquire at least one of them to complete the Section 1031 Exchange.

5.  The property owner cannot take back the sales proceeds from the sale of the Relinquished Property.  In either case, the Intermediary will hold the net sale proceeds until Day 46 if Replacement Property(s) were not identified, or on Day 181 if Replacement Property(s) were identified. 

6.  The Exchange Documents provided by the Intermediary must be signed in advance of both the sale and the purchase of any properties involved in the Exchange.

Conclusion

If you are selling a “business or investment property” such as commercial property, and reinvesting the sale proceeds in other business or investment (rental) property, then working with your broker and a Qualified Intermediary such as CDEC to structure your sale and purchase as a Section 1031 Exchange can, in many cases, defer significant capital gains taxes.  Like other aspects of the IRS Code, exchanges can become fairly complex, so we encourage property owners who are considering a Section 1031 Exchange to seek professional advice.

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