A 1031 exchange is a fantastic way for businesses or investors to delay paying capital gains tax on the sale of their properties. However, as you might expect, to take advantage of this tax exemption you must fulfil specific criteria. Failure to do so could mean that you are liable for the tax you have tried to re-invest, plus any additional penalties.
Some of the core requirements that must be met in order to qualify for a 1031 exchange include:
Both properties are held for investment
The single most important element that must be met in order to qualify for a 1031 exchange is that both properties – the relinquished property and the one that you wish to buy – are held for ‘productive use in a trade or business or for investment’. This means that a sale or purchase of a primary residence does not qualify for a 1031 exchange.
The properties must be ‘like-kind’
Another key rule for a transaction to qualify for a 1031 exchange is that your initial property must be relinquished for an investment that is ‘like-kind’, something which the IRS defines as being of ‘the same nature, character and class’. Examples include:
- Exchanging a hotel for an office building
- Exchanging an office building for a shopping center
- Exchanging a farm for an apartment building
Your 1031 exchange facilitator will be able to provide you with more advice as to whether your proposed transaction will qualify for a 1031 exchange.
You must use a qualified exchange facilitator
In order to qualify for a 1031 exchange, you must use a qualified intermediary/exchange facilitator from the very beginning of the process. You are unable to take control of the proceeds of the sale of your old property and use them to purchase your new one. Instead, your exchange facilitator must hold the funds on your behalf and use them to secure your like-kind property.
You must re-invest all cash proceeds from your sale
Ideally you should ensure that you use all cash proceeds from your sale in your new investment. Your new property should also be equal to or greater in value than your relinquished property. That said, it is possible to qualify for a 1031 exchange when purchasing less than you have sold although doing so is not without consequences. Your exchange facilitator can advise you what these would be.
The 45-day rule
Once you have sold your old property, you will have 45 days during which to purchase your replacement property or provide a list of potential properties that you are considering for your 1031 exchange. There is no way of extending this period and there are no exceptions to this 45-day rule. If you choose to present a list of potential investments, this should meet several criteria, including:
- Specifying the exact property and it’s address so that an auditing IRS agent could find and assess its suitability for a 1031 exchange.
- A maximum of three property options
- The list must be provided in writing to your exchange facilitator
The 180-day rule
For a transaction to qualify for a 1031 exchange, you must have purchased your chosen replacement property within 180 days after the closing of your relinquished property. If you provided a list of potential properties to your exchange facilitator, the purchase must be one of those listed. Again, there are no extensions to the 180-day rule and there are no exceptions granted.
If you have further questions about how to qualify for a 1031 exchange, our expert team of qualified intermediaries would be delighted to help. Please contact our Carlsbad, CA office and get in touch and let us help you negotiate this valuable tax-saving strategy.