1. Set Up the Exchange Prior to the Sale
First things first—timing is crucial. The 1031 Exchange must be set up before you sell your relinquished property. An arrangement must be made with a Qualified Intermediary, who acts as the steward of the process.
- Contact a Qualified Intermediary before making a sale.
- The Qualified Intermediary will guide the escrow company to hold your sales proceeds safely.
- The IRS mandates that you can’t handle the sales proceeds directly to avoid “constructive receipt” of the funds.
Your Qualified Intermediary will also help you with the identification of the replacement property within the prescribed timeline.
2. Look for Like-Kind Property Only
One of the common myths is that the replacement property must be exactly the same as the relinquished property. That’s not true. The IRS defines like-kind property broadly. It includes all properties held for business or investment purposes.
Types of Like-Kind Property:
- Rental homes, commercial buildings, agricultural lands, and even unconventional ones like cell towers and water rights.
- Exceptions include personal residences and properties intended solely for resale.
If you’re in doubt, consult your advisor to make sure your property fits the bill.
3. Ensure the Replacement Property is of Equal or Greater Value
Your replacement property must be equal or greater in value than the relinquished property, minus any selling costs.
- Sales Price: $1M
- Closing Costs: $50K
- Net Sales Proceeds: $950K
Note that mortgage or loan payoffs are not deductible from the “equal or greater value” calculation. Be sure to use all of your net equity to acquire the replacement property.
4. Understand the Tax Implications of “Boot”
“Boot” refers to any economic benefit you gain from the exchange. You will need to pay capital gains tax on any boot received.
Tax Rates on Boot:
- 25% Federal tax rate for depreciation recapture.
- 15%-20% Federal capital gains tax, plus state-level taxes if applicable.
5. Maintain Entity Consistency
The legal entity that sells the relinquished property must be the same as the one buying the replacement property. This rule ensures transparency and continuity in the exchange process.
- Multi-member LLCs or Partnerships often change to Tenant-In-Common (TIC) structures before a sale, offering flexibility for multiple co-owners.
6. Meet the 45-Day Identification Deadline
Time is of the essence. From the sale of the relinquished property, you have only 45 days to identify replacement property(s).
Methods of Property Identification:
- Three Property Rule: Identify up to three properties.
- 200% Rule: Identify any number of properties not exceeding 200% of the relinquished property value.
- 95% Rule: Close on 95% of the aggregate value of identified properties.
7. Complete the Exchange in 180 Days
After identifying the replacement property, you have 135 more days to close the deal, making it a total of 180 days for the entire process.
Tax Filing Consideration:
- If your 180-day period extends into the next calendar year, do not file your taxes for the current year until the exchange is completed.
Time to Act is Now
Understanding these key rules will set you on the path to maximizing your investment returns while minimizing tax liability. The process can be complex, but missing out on this opportunity can be costly. Act now to leverage the 1031 Exchange to your advantage. Reach out to one of our trusted 1031 Exchange Advisors and get started today!