This is the last article in our 1031 Exchange series. Previously we talked about reasons why you should use a 1031 Exchange tax shelter and how to use a 1031 Exchange. Today we are going to discuss some of the 1031 exchange rules and regulations. You need to be aware of these before you start the investment real estate exchange process.
Just as a way of review, a 1031 Exchange allows you to sell an investment property and then use the proceeds to re-invest into another “like-kind” investment property without having to pay any capital gains or depreciation recapture taxes. This means that utilizing a 1031 Exchange will give you another 13 percent of the sale proceeds that you can use towards your next investment. What is even nicer is that based on the vague definition of like-kind, pretty much any type of investment property qualifies. Just as long as you will not be using the property for personal use.
1031 Exchange Rules
How about we take a few minutes and go over some of the 1031 exchange rules and regulations. The 1031 exchange rules affect the time it takes to complete the transaction. It also impacts the value of the replacement properties.
The 1031 exchange rules are pretty strict when it comes to the time period you are given to complete the exchange. So, you need to get all your ducks in a row before you close on your first property.
After you close on the sale of the first property, you have 45 days to nominate a potential replacement property or properties. You must be able to specify an address and the probable purchase price of the possible replacement property. You can include a couple of backup properties incase the first choice doesn’t pan out.
After you close on the sale of the first property, you have a maximum of 180 days to close on the replacement property. There is some fine print on this 1031 exchange timeframe rule. The IRS wants to keep all the paperwork together. So, the last day that you can close on your replacement properties is 180 days from the sale or before you must file your tax return – whatever comes first.
If you sell your property on November 15th, then you have until May 14th to close on the replacement. Your tax return, however, is due on April 15th. So you would need to close on your replacement property by April 15th unless you file an extension.
Another 1031 exchange rule is that the total value of all the identified properties cannot exceed 200% of the sales price of your initial property. If you sold a warehouse building for $450,000, you can identify as many replacement properties as you like. Just as long as the total sum does not exceed $900,000.
Three Property Rule
This 1031 exchange rule allows you to identify only three properties. But there is no limit on the total value of all the identified properties. If you sold that same warehouse building for $450,000, you could choose a $600,000 multi-family, a $2 M storefront or another warehouse building for $450,000.
Replacement Property Value
When it comes to 1031 exchange rules, the IRS has set only four general rules regarding your replacement property. That is if you want them to be fully tax deferred.
1031 Exchange Rule #1 – Value Equal or Greater
The total value of the replacement property or properties must be equal or greater than the net sales price of the sold property. That warehouse building of yours sells for $450,000 and you paid $27,000 in closing and commissions. This netted you $423,000. The total of your replacement properties must be at least that amount.
1031 Exchange Rule #2 – Replacing Debt
The total value of the debt on the property must be replaced in the new property that you are purchasing. When you sold your warehouse, you paid $27,000 in closing costs and also paid off a $315,000 mortgage. You now have $108,000 of cash to buy a replacement property. Remember, Rule #1 requires the value of the replacement property must be equal or greater than the net sales price. You will have to figure out how to come up with the additional $315,000. You could get another mortgage or you can infuse the purchase with more cash. The choice is yours but the amount of the debt must be replaced.
1031 Exchange Rule #3 – Paying for the Extra
If your replacement property or properties have a higher purchase price than the value of your sold property, the difference in value can come from either cash or a mortgage. Let’s say you sell your warehouse for $450,000 but decide to invest in a 25-unit multi-family property for $875,000. That is perfectly legal and you can get a mortgage to cover the difference.
1031 Exchange Rule #4 – Pulling Out Money
If you choose to pull out some money from the sale, you will owe capital gains on it. This also includes purchasing properties that have a lower value. Capital gains taxes will be owed on the difference even if you will use the proceeds later on to purchase another property outside of the exchange. You sell your $450,000 warehouse and invest the proceeds into a $425,000 duplex. You keep $25,000 to put towards your kids college fees. You will owe capital gains on the $25,000.
Now that you have an overview of the 1031 exchange rules, we hope that you will decide to utilize the tax savings features of a 1031 exchange in the future. Your CPA, attorney, and qualified intermediary will help walk you through the whole process.