1031 Exchange Rules (10)

1031 Exchange Rules are stated and explained incorrectly by all of the hits on the first page of a Google search for that term.

That means that about 90% of the people are being misinformed,  if that is the number of searchers who do not go past the first page.

Today, I would like to give you the correct information.

If you are interested in reading the Section 1031 Exchange Rules, they are contained in Internal Revenue Code Section 1031(a)(1) and Treasury Regs Section 1.1031(a)-1.

If you need to check my credentials, this is my Bio and here are the two books that I have written on the subject, and here is one of my websites that has all of the information you will ever need on the Section 1031 Like Kind Exchange.

If you are doing, or considering doing, a Section 1031 Like Kind Exchange, there are ten rules that you will need to know.

1031 EXCHANGE RULE #1: LIKE KIND PROPERTY

The property that you sell to start off the Section 1031 Exchange process is called your Relinquished Property.  It will be either real property, or it will be real property combined with personal property.

The property that you buy, your Replacement Property, will be either real property, or it will be real property combined with personal property.

The personal property we are talking about here is what the IRS calls “tangible personal property” and not your personal possessions.

Tangible personal property is the portion of the real estate that is not part of the basic structure.  These are items like the furniture and fixtures, and heating and air conditioning systems.

They are items with a depreciable life of 20 years or less.

The Tax Cuts And Jobs Act (TCJA) eliminated the use of the Section 1031 Like Kind Exchange for just personal property, by itself.  Section 1031 now only applies to real property.  But the real property includes the items of personal property that are part of it, which would be ineligible if they were treated alone.

So, what about the “like-kind” requirement?

The real properties must be “like-kind” to each other, and the personal properties must be “like-kind” to each other.

Now, this does not mean that the real properties are “like” each other in their physical appearance, but are “like” in their use or characterization, such as both properties being used as business or investment properties.

That’s all.  A warehouse is “like” a duplex if they are both investment properties.

For personal properties, it does actually mean that they are like in appearance, as well as like in almost every other way.  Refrigerators for refrigerators, washing machines for washing machines, etc.

RULE #2: BUSINESS OR INVESTMENT PROPERTY

The next 1031 Exchange Rule requires that the Relinquished Property be “property held for productive use in a trade or business or for investment.”  That refers to what you are using the property for right now, at the time that you are doing the sale.

The Replacement Property, however, must be property “which is to be held either for productive use in a trade or business or for investment.”  That refers to what you will use the property for after you buy it.

It is critical that you understand this distinction, it is part of the foundation of the 1031 Exchange process.

It is somewhat involved, and an explanation of which properties meet this definition can be found at Dealer Property, and expanded on at Intent.

RULE #3: REPLACEMENT PROPERTY PRICE

The price that you pay for the Replacement Property must be equal to, or greater than, the sales price of the Relinquished Property in order to qualify for a Total Tax Deferral.  If it is less, you can still qualify for a Partially Tax Deferred Section 1031 Exchange.

Your Replacement Property can be more than one piece of property, see the 45-Day Rule below.

RULE #4: NET SALES PROCEEDS

The Net Sales Proceeds is the amount that you are entitled to receive at the Closing on the sale of your Relinquished Property.

The rules of the 1031 Exchange require that all of your Net Sales Proceeds be used when you purchase your Replacement Property.

If you take out part of the Net Sales Proceeds at the Closing and keep them, that part will be taxable to you as what the IRS calls “boot.”

The rate at which you will be taxed will depend on how much you take, how much Depreciation you have claimed in the past, and what Capital Gains Tax bracket you fall into.  You can explore this further at S1031Exchange.com.

RULE #5: SAME TAXPAYER

This is a rule that causes trouble for quite a few taxpayers, because they have not managed their legal activities very well regarding their business entities.

The rule says that the name that goes on the deed when you receive the Replacement Property must be the same name that was put on the deed for the Relinquished Property when you bought it (and it better be the same name you used when you sold it).  It can be your name as an individual, or an LLC, a C Corp, an S Corp, a Partnership, etc.

You might have a problem if you bought the property in your own name and then put it in an LLC and sold it.

However, if you sell the Relinquished Property as an individual, and you buy the Replacement Property in the name of an LLC in which you are the sole member, and you have elected to be treated by the IRS for tax purposes as a Disregarded Entity, the seller and buyer are considered to be the same under the 1031 Exchange Rules.

RULE #6: THE 45-DAY PERIOD

This is the first of the two “1031 Exchange Timelines.”

The 45-Day Rule is that the date on which you Close on the sale of your Relinquished Property is called the “Exchange Date.”

Within 45 days of this date, you must identify in writing the property that you intend to purchase as your Replacement Property.

There are three methods you can use to identify the property or properties that you will purchase.

  1. First, you can identify up to three properties without regard to the value of each, or the total value of all three.
  2. You can identify as many properties as you want, as long as the total value of all of the properties is not more than 200% of the value of the Relinquished Property.
  3. And the most complicated of the 1031 Exchange Rules, you can identify as many properties as you want, without regard to the “200%” limitation, as long as you end up closing on enough of the properties to represent 95% of the total value of all of them.  This option is seldom used because it is so difficult to understand and to follow.

You make the identification in writing, usually to your Qualified Intermediary.

RULE #7: THE 180-DAY PERIOD

The second of the two “1031 Exchange Timelines” is the 180-Day Rule.

The Rule states that you must close on the purchase of your Replacement Property within 180 days after the Exchange Date described in the Rule above

There are consequences for you if you do not do so.

  1. The entity holding your Net Sales Proceeds will distribute those funds to you,
  2. You will not be permitted to engage in a Section 1031 Exchange, and
  3. You will pay Capital Gains and Depreciation Recapture Tax on the sale.

The IRS will not impose penalties or interest.

But there is no appeal of this situation.  Miss the 180 day point, and the 1031 Exchange is off.

RULE #8: RELATED PARTY

First, let’s explain what a “related party” is.

Related Party means your spouse, your brother, your sister, your child, your grandchild, your parent, or your grandparent.

One of the Rules of Section 1031 Exchange is that you cannot sell your Relinquished Property to, or buy your Replacement Property from, a person related to you, a Related Party, without having certain conditions imposed.

A Related Party also includes a corporation, partnership, Limited Liability Company, or similar business entity in which you own more than 50% of the interest.  This percentage includes your spouse’s ownership.

Related Parties are allowed to do a direct swap of properties, but each party must hold the acquired property for a period that is more than two years after the date of the last transfer.

Also, each Related Party must continue to file Form 8824 for two years following the year of the Exchange.

In addition to swapping properties, the Rule permits you to sell your Relinquished Property to a Related Party, but if you do so, the Related Party is required to hold the property for the two-year period described above.

If the Related Party fails to do so, the transaction will be declared invalid under the 1031 Exchange Rules, and taxes, penalties, and interest will be imposed on both parties, so if you do this, be very careful who you do business with.

You will be held to the same two-year filing requirement for Form 8824, except that it could turn into three years for you because the period will start to run from the date that you acquire your Replacement Property, and this could be 180 days after the first Closing, and could cover three tax-filing periods.

If you want to buy a Replacement Property from a Related Party, you can do so, but you will have the same two-year reporting requirement for Form 8824.  And it will almost guarantee that the IRS will audit the transaction because this is where they find most of the abuse of the Section 1031 Exchange, family members trying to game the system.  So, this is where they are looking.

RULE #9: QUALIFIED INTERMEDIARY

Of all the 1031 Exchange Rules, the most important is the one that says you cannot have actual receipt of, or constructive receipt of, or control over the Net Sales Proceeds.

Violate this one Rule, and the 1031 Exchange is over immediately.

You must sign a document called an Assignment of Benefits of your Sales Contract for your Relinquished Property to an independent third party.

Usually this third party is what the IRS calls a Qualified Intermediary.

The name “Qualified Intermediary” does not mean that the individual or entity is “qualified” in any way to do anything, and they often are not qualified.

A Qualified Intermediary, generally referred to as a QI, is an entity that is not disqualified by the IRS from providing the service, by reason of having had a family or business relationship with you during the past two years.

Think about that.  It is the crux of the problem.  The IRS decided to refer to anyone who has not been disqualified as being “qualified.”

That is not the definition of “qualified.”

So the only reason that the IRS refers to them as qualified (intermediary) is that they are not disqualified by the IRS’s definition of being disqualified.

It has nothing to do with their ability to do the job.

The QI is not licensed, or even registered, by the IRS, or any other federal, state, or local government regulatory agency.

Their activities are completely unregulated.

The IRS, in their Tax Gap series fact sheet, even warns about them:

“Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligation to the taxpayer.  These situation have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain.  The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.”

This is the IRS telling you that if you turn over $400,00 from the sale of your Relinquished Property to your QI to be used in the purchase of your Replacement Property, and the money disappears, you not only lose out on the Replacement Property, you’ve lost your Relinquished Property, your money is gone, and you still owe the IRS the Capital Gains Tax.

You can read an example of disappearing Escrow Account funds here.

RULE #10: ELECTIONS

The most common question I get from readers who have already done a 1031 Exchange involves what to do about Depreciation.

You see, when you sell your Relinquished Property, you will still have some basis in it that you have not depreciated (unless you have held it for 27.5 years, which you probably have not.)

What happens to the Depreciation that you have not claimed?

Well, believe it or not, you are permitted under the 1031 Exchange Rules to continue to claim depreciation on this amount even though you no longer own the property.

But there are two possible ways to do it, and you must tell the IRS which method you want to use.  The IRS calls it making an “Election.”

You can either continue with your current depreciation schedule and continue to claim whatever depreciation amount you have been claiming each year.  Call your depreciation schedule “Old Basis.”

You would now have a new depreciation schedule for your basis in the Replacement Property and call it “New Basis.”

Or, you can combine the basis in the Relinquished Property, it is called Transferred Basis, with the basis in the new Replacement Property, and start a completely new depreciation schedule on that total amount.

But you must tell the IRS which one you are doing.  You do that by checking the appropriate box on your Form 4562 that says, “Election Made Under Section 1.168(i)-6T(i)” on the next tax return that you file.

1031 EXCHANGE RULES: CONCLUSION

Well, that’s it.

The Internal Revenue Code Section 1031 does not actually contain a list of Rules.

But if you read and understand Section 1031 and the Treasury Regs, and then handle 1031 Exchanges for a number of years, you will know what the “Rules” are, and how to state and explain them.

I recently read an article on 1031 Exchange Rules on one of the top websites devoted to real estate investing, and the writer said that you must take out a mortgage on the Replacement Property that is equal to the mortgage that was paid off on the Relinquished Property, and added, “You cannot use your own cash.”

This is total nonsense, and it would just be more of the same on the internet, except that it is on a site that a lot of people rely on for accuracy.

Be careful, a 1031 Exchange involves a lot of money, and the IRS is totally unforgiving in this one area.

You mess it up, and your 1031 Exchange is toast.

RESOURCES

I touch on this same concept in more than one of my books, but the one with the most detailed information is “How To Do A Section 1031 Like Kind Exchange” and the OMNIBUS EDITION of the same.  You can go here on this website to look at the first one, use the 3D Flip Reader to look at the Contents and read the first few chapters.

The paperback is available on my Amazon Author Page, along with my other books.

And I have related Articles about real estate investing and other real estate matters from other perspectives on my LinkedIn Page.

I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.

If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then you will really appreciate the value of what we are talking about, and I have a lot of material for you to consider on my S1031 Exchange website.

You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography.  Here’s mine.

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Thank you.

DISCLAIMER:  I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia.  But I am not your Attorney.  I would be honored if I were, but I am not.  Reading this Blog does not created an attorney-client relationship between us.  Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.

 

April 3, 2022

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