A 1031 exchange is a part of the IRS 1031 tax code that allows you to reinvest potential gains from the sale of an investment property into one or more replacement properties while deferring payment of capital gain taxes on the appreciated gains. If you plan on deferring capital gain taxes using a 1031 exchange, specific rules are guiding it. Below are some of the simplified rules governing a 1031 exchange in 2020.
What Are the Rules of the 1031 Exchange in 2020?
- Rule 1: The Exchange Properties Must Be Like-Kind
The IRS stipulates that the property you are selling (relinquished) and the new property you are buying (replacement) must be like-kind. Like-Kind property is a property that is held for investment, trade or business purposes. Generally, any investment property will qualify as a like-kind except for your personal residence.
- Rule 2: You Must Identify Your Replacement Property Within 45 days
According to the IRS 1031 code, you must identify one or more properties as your potential replacement property within 45 days. Your 45-day identification timeline starts at the closing of your relinquished property. You can opt-in for either of the three identification rules—three-property rule, 200% rule, and the 95% rule.
- Rule 3: You Must Close on The Replacement Property Within 180 Days
According to Dwight Kay, founder and CEO of Kay Properties and Investments “Before you can complete a 1031 exchange, you must close on the replacement property within 180 days from the sale of your relinquished property. You must understand that the 180 days’ timeline cannot be extended except on certain conditions. So, if the 180th day falls on a weekend or national holiday, the IRS will not hesitate to tax you on capital gains. An exception to this rule is if the 180th day falls on the due date of your tax return, the IRS may allow you to file for an extension. “
- Rule 4: You Cannot Exchange A Local Property for A Foreign Property
The IRS is still strict on this aspect of the 1031 exchange. You cannot exchange your rental home in Alabama for a rental home in Monaco or Spain and qualify for capital gain tax deference. In a nutshell, you can only trade domestic properties for domestic properties and international properties for international properties. Remember, in this context, domestic properties refer to properties within the US, and foreign properties refer to properties beyond the border of the US.
- Rule 5: You Must Use A Qualified Intermediary (QI) To Handle the Exchange
The IRS stipulates that you cannot carry out a 1031 exchange personally. This is because you can’t touch the funds in between the sale of your old property and the purchase of a new property. It must be handled by an independent third party known as a QI. The QI help you prepare the exchange documents, holds the money in an escrow account, and manage the purchase of the new property.
- Rule 6: You Must Reinvest the Entire Sale Proceeds
Before your exchange can qualify for capital gain tax deference, you must reinvest the entire proceeds from the sale of your relinquished property. So, if you sold your relinquished property for $200k, you must find a replacement property that is equal to the $200k or higher in value.
- Rule 7: Cash You Receive in An Exchange is Taxable
Most of the time, there is always a difference in the market value of the properties used in a 1031 exchange. If you exchange your like-kind property for a more valuable property, then you will have to pay extra cash to the seller. Remember that this extra cash you are paying is not subject to tax. For example, you sold your old property for $300k and bought a new one for $370k, the extra $70k you paid to the seller of the new property is not subject to taxation.
However, if you make an exchange for less valuable property and you’re the one who receives some extra cash, then the cash received is subject to tax. A good example is if you sold your property for $300k, then buys a new property for $250k, the extra $50k is subject to capital gain tax. Notwithstanding, the cash you receive is usually lower than the total gain on the property.
- Rule 8: 1031 Exchange Don’t Have to Be Direct
In the past, a 1031 exchange was quite direct in its process. It was more of a simultaneous exchange where you find someone that owns exactly your property (both in value and asset type) and is willing to exchange. This made the 1031 exchange strategy difficult to practice. Although, in recent time, the IRS now allows you to sell your old property first and close on the new property later. This is known as the delayed exchange. Besides, you may decide to purchase the replacement property first and sell your relinquished property later. This type of 1031 exchange is known as the reverse exchange.