Keys to 1031 Exchanging | Institutional 1031

The tax deferred exchange of your property completed pursuant to IRC Section 1031 doesn't have to be difficult. But when dealing with multiple properties and their transactional logistics, understanding the process and having access to a trusted expert is the best strategy for a painless, successful exchange. Here are the key "rules of the road" experienced exchangers always follow.

The properties you exchange must be like-kind

The property you sell and the property you buy must both be real property held for productive use in a trade or business or for investment (IRC §1031(a)(1)). A personal residence does not qualify. 'Like-kind' refers to the nature or character of the real property, not its grade or quality, so most U.S. investment real estate is like-kind to most other U.S. investment real estate.

You must utilize a Qualified Intermediary

Nearly every deferred exchange uses a qualified intermediary. The QI is a safe harbor under Treas. Reg. §1.1031(k)-1(g)(4): with it in place before the relinquished property transfers, the exchanger is treated as not having received the sale proceeds. This should be a well-established firm like Institutional 1031, so you know your exchange documentation will be correct and your exchange funds will be safe between the time you buy and the time you sell.

You have a total of 180 days to complete your exchange

You must complete your sale and purchase within a total of 180 days, or by the due date of your tax return for that year, including extensions, whichever comes first. The tax return qualifier means that if you start your exchange late in the year, you might have to file for an extension to receive your full 180 days.

You must identify replacement properties within 45 days

While you have 180 days to complete your exchange, the IRS requires you to identify candidate or target replacement properties within the first 45 days. Usually this identification is made to your Qualified Intermediary by completing a form kept in your exchange file. The identification must be in writing, signed by you, and sent to the intermediary (or another permitted party) before midnight on the 45th day. You may identify up to three properties of any value, or any number whose combined value does not exceed 200% of what you sold.

There are different types of exchanges

While most exchanges are deferred exchanges, others may better suit your situation. If you must buy before you sell, consider a reverse exchange. If your replacement property needs improvement or construction, consider an improvement exchange. And if your construction exchange must exceed the 180-day Safe Harbor timing, inquire about a Non-Safe Harbor exchange.

Three things that together give full deferral

First, buy replacement property equal to or greater than the net selling price of what you sold. Second, move all your equity from the old property into the new property. Third, replace the debt — with new debt or with additional cash.

Avoid these two critical 1031 pitfalls

First, make sure your exchange funds are safe, and insist on a well-established QI and a Qualified Escrow Account. There are relatively few federal rules for intermediaries; some states, including California, regulate exchange facilitators (Cal. Fin. Code §§51000–51015). Ask any intermediary how funds are held, who can authorize a disbursement, and what bond and insurance are in place. Second, start looking for replacement property as soon as possible; the 45-day identification period moves very quickly.

Buy replacement property as the same entity in which you sold

It is always better to buy and vest your replacement property in the same name and entity in which you sold. Changing entities mid-exchange could cause your exchange to fail for lack of meeting the same-taxpayer principle — the taxpayer who sells must be the taxpayer who buys, for federal income-tax purposes. A single-member LLC or grantor trust that is disregarded for tax purposes may hold title; a change to a different taxpayer mid-exchange is the risk.

You can revoke and re-identify within your 45-day period

If you are still within your 45-day identification period, you can revoke a previous identification and re-identify new replacement property. A revocation must be in writing, signed by you, and sent before the end of the 45-day period to the same person the original identification went to (Treas. Reg. §1.1031(k)-1(c)(6)). Then send the new identification the same way.

Getting access to tax-free cash can be tricky

Cash-out refinancing before or after an exchange raises timing questions; discuss it with your CPA before you list. Borrowing too close to the start of your exchange could create an argument that it was part of a stepped transaction and therefore not eligible for deferred gain treatment.

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