The 5 Commandments of a 1031 Exchange
The key to the success of your 1031 exchange hinges on the adherence to a specific and very rigid list of requirements from the IRS. These requirements are not a buffet from which you choose, your transaction must meet all of these requirements or there is no valid 1031 exchange in the eyes of the IRS:
1. The Intent to Hold for Investment Purposes
The specific wording within the IRS code states that real estate that qualifies for 1031 treatment is: “…property that is held for productive use in trade, business, or for investment.” In other words, the type of real estate does not matter. Any type of investment real estate can be exchanged for any other type. So you can exchange residential for commercial real estate, raw land for duplexes, and office buildings for condos. As long as it’s intended to be held for investment and it’s real estate it’s good for 1031.
2. 45-Day and 180-Day Rules
From the day that you close the sale of your investment property, it is important for you to know that there are two time periods you absolutely must respect — the identification period and the exchange period.
From the day you close the sale of your old property you have 45 calendar days to identify your potential replacement properties. Forty-five calendar days is all you have, and that includes Saturdays, Sundays, and holidays.
The most critical aspect of the 45 day list is that on day 46 you are stuck with whatever is on that list for the remainder of the exchange period. Even if the properties on the list are no longer logistically available, the list cannot be changed. This is why it is best if you can get your new property under contract and even close on it during the first 45 days so you can mitigate risk and give your exchange the best chance of success
Concurrently, with the 45 day period is the total exchange period of 180 days. From the day that you close the sale of your property, you have 180 days to complete the process. The purchase has to be one or more of the properties that are on your 45 day list.
Is there a limit on the number of properties one can add to their 45-day list? Can you just add everything on the market to your “Maybe List”?
There are specific rules for that, of course! If you put three or fewer properties on your list, there are no restrictions.
However, if you put four or more properties on your 45-Day List, there are restrictions based on the sale price of the property you sold to start the 1031 exchange:
If you list 4 or more properties, the total value off all of the properties cannot exceed 200% (double) the sale price of the initial sale, or…If you list 4 or more properties, and the total value is greater than 200% of what you sold, then you have to buy 95% of the value of what’s on your list.
Needless to say, it’s crucial to keep these guidelines in mind, and determine which option best aligns with your financial position and intent.
That sounds easy enough. But real estate deals fall apart all the time. What happens if I plan to do a 1031, but the deal doesn’t close?
There is no penalty for starting and not finishing a 1031 exchange. If you start a 1031 exchange but do not complete it because of a 45 day issue, or any other reason, you simply do not report the exchange at all on your next tax return. Because the regulations state that the 1031 must be done prior to your next tax filing, it guarantees that you will never report a failed 1031 exchange on your tax return.
3. Qualified Intermediary Requirements
A qualified intermediary (QI) is required by section 1031. They must be an unrelated third party and they must be involved prior to the closing of the old property. If you close the sale of your property without an intermediary in place, three things happen that are prevent you from doing an exchange. First, the QI was not involved per the IRS code. Second, the exchange was not documented properly on the closing documents and statements. Third, you received the money. The IRS will not allow you to have control of your money when you are doing a 1031 exchange. Whether you have the actual money or whether the money is sitting in your attorney’s escrow account or your title company’s account, waiting for your direction, it is not allowed. It cannot be emphasized strongly enough. Your QI must be in place prior to the closing of the sale of your old property. And of course as you can see from the complexity of the rules a 1031 exchange is not a DIY process.
The QI is your guide through the maze. Vet each intermediary that you interview. You want to look for a QI who has experience, a reputation in the industry, and who has demonstrable results. Selecting a good QI is one of the most important steps to ensure that your 1031 goes as planned and results in as few grey hairs as possible.
4. Title/Taxpayer Requirements
Any tax-paying entity that owns real estate can do a 1031 exchange, whether a corporation, a partnership, an LLC, a trust, or an individual. But whoever the taxpayer is on the old property has to be the taxpayer for the new property. In general terms, that means that if you own a piece of property and sell using a 1031 exchange, then you have to be the buyer of the new property; Or if the property is held in an LLC or corporation, that same LLC or corporation must be the purchaser of the new property as well.
PRO TIP: Don't name your LLC's after property addresses! Often, people end up doing a 1031 Exchange later on, and "123 Main Street LLC" ends up owning the property at 456 Central Ave - which can make things confusing down the road.
5. Reinvestment Requirements
The last requirement is the reinvestment of the cash. This one trips up a lot of people. The statute is really a two-part rule. First, in order to defer all tax, you must purchase at least as much property as your net sale. Second, you must use all the net proceeds in the purchase or purchases. So, you are going to have to buy as much as you sell in order to defer all of the tax.
There is a quick and dirty way to calculate your reinvestment target. Spend whatever cash goes into your exchange account from the sale. Then add to that whatever mortgage was paid off. That is how much you need to purchase in order to defer all tax.
What if I want to buy another property with a 1031, but I also need some of the cash?
If you are willing to incur some tax you may purchase less than your net sale. And you may take cash out without jeopardizing the entirety of your 1031 exchange. But if you want to purchase less than what you sold or you want to take some cash out, the IRS will call that “boot” and it will be taxed as profit first.
Is that all? (It actually sounds pretty complicated!)
These are the five requirements for a successful 1031 exchange. They can seem daunting to an investor if you are just starting out. However, once you have one under your belt, it really is as simple as finding a great QI to work with, and then sell and buy real estate, while jumping through a few hoops in-between! And once you start learning to properly utilize the power of the 1031 exchange, it can really help you scale up your investing goals.
What about flippers? Is there any way for a “flip” to qualify for a 1031 exchange?
Usually not. The IRS looks at the purchaser’s intent, as well as what actually occurred. For most flippers, whose goal is to rehab and sell as soon as possible (not to hold and rent the property out “for investment purposes”), the IRS would look at the property as their “inventory” – not much different from any other business that buys materials, increases their value in some way (by turning them into something new, or through marketing, or both), then sells them at a markup at “full retail” prices. The difference between your cost of goods sold and your retail sale price is your gross profit, and taxes on that kind of operation can’t usually be deferred.
The exception to this might be an investor who buys a house, renovates it, rents it out for a year or two, then sells it. That would likely qualify for a 1031 if the profits were invested in another real estate deal.
And this model is something that a lot of flippers should maybe think about. If your net profit on a flip is $50k, and your tax bracket is 28%, you would defer $14,000 on taxes on each deal – so it can have a huge impact on your ability to scale up if you are in a position to hold the properties and rent them out for a year or two, then reinvest the profits (if you need the money to pay bills or whatever, then it’s probably a moot point).