How a 1031 Exchange Works
Step 1: Sell Your Property (aka “Relinquished Property”)
Must be Non-owner occupied investment property NOT your Primary Residence
(Primary residence already has 250 K-single/500 K-married owner(s) IRS 121 Exemption)
Must be USA Real estate only!
Must be MIRROR IMAGE: SAME SELLER NAME & SAME BUYER NAME
Must be Long Term Holder, property can’t be a stock in trade “dealer” property (No Fix & Flippers)
For total tax avoidance property should be a paid off asset & should NOT be sold to a buyer with any seller carry back financing!
Step 2: Sale Proceeds Parked with Qualified Intermediary (QI)
The QI handles the financial part of the exchange by taking receipt of the sales proceeds from the sale of your original property (relinquished property) and distributes the proceeds to pay for your replacement property(s).
Note: The QI must be a non-related disinterested third party.
Step 3: Identify Replacement Property (s) within 45 Days
The Internal Revenue Code requires that the new property be identified within 45 days of the closing of the sale of the old property. The 45 days commence the day after closing of Relinquished Property and are calendar days. If the 45th day falls on a holiday, that day remains the deadline for the identification of the new properties. No extensions are allowed under any circumstances. If you have not entered into a contract by midnight of the 45th day a list of properties must be furnished and must be specific. It must show the property address, the legal description or other means of specific identification.
IRS Rules of Replacement Property Selection:
200 Percent Rule - can identify 4 or more properties as long as the value does not exceed 200 % of the property sold.
3 Property Rule - can identify any three properties regardless of value.
95-percent Exception Rule - if value exceeds 200 %, then 95 percent of what is identified must be purchased.
Step 4: Close on Identified Replacement Property (s) within 180 days
The property being purchased must be one or more of the properties listed on the 45 day identification list given to your QI. You can replace any replacement property prior to 45 day ID period. But after the 45 day ID period that’s it! This time frame runs concurrently, therefore when the 45 days are up you only have 135 days remaining to close. There are no extensions due to title defects or otherwise. Closed means title is required to pass before the 180th day.
Any money or the fair market value of “Non like-Kind Property” received by you in a 1031 exchange relinquished or replacement property closing is taxable (to the extent of gain realized on the exchange). This taxable income is commonly referred to as “Boot”. If you desire some cash out and are willing to pay some “Boot” or taxes this is OK, but mortgaging replacement properties TAX FREE post 1031 with no “Boot” or tax bite is a much better option
Common Sources of 1031 Taxable "Boot"
You buy a replacement property with a lesser value then the original property (Relinquished)
SOLD Price & BUY Price positions must be equalized after 1031.
Ex: Sold Relinquished asset for $600,000 Net | Bought $500,000 Replacement asset (s)|Incur $100,000 tax bite (boot)
Taxable Cash Received
Any cash received, controlled or ‘touched’ by you at the closing of either the relinquished property or the replacement property is taxable.
Taxable Debt Relief
Any mortgage or loan that an you pay off at the closing of the sale of your old property will be taxable as debt relief by the IRS unless you can
1) Replace the old debt with an equal larger new loan
2) You increase the amount of cash invested in the new property by the amount of debt relief.
Example: The old property is sold for $500k; $160k goes to pay off the mortgage and $340k goes to the QI. Then, the investor purchases a new property for $500k. The $340k held by the QI goes toward the purchase, but the investor is still short $160k. This shortage can come from either a new $160k loan or $160k of additional cash that the investor brings to the closing, OR a combination of the two.
If you sell your old property and hold paper, the mortgage note received by you is considered "Non Like Kind Property" and is taxable.
Using sale proceeds to pay for non-transactional closing costs.
The IRS stipulates:
To pay closing costs out of exchange funds, the costs must be considered a Normal Transactional Cost. Normal Transactional Costs, or Exchange Expenses, are classified as a reduction of boot and increase in basis, where as a Non Exchange Expense is considered taxable boot or non-transactional closing costs.
1031 Normal Transactional Closing Costs
Permissible Closing Cost expenses in a 1031 Exchange