Timing around a 1031 tax exchange can be confusing and difficult to meet. It’s important to understand the rules and policies around spcific timing issues when it comes to 1031 transactions. Many people miss deadlines or are unaware of exceptions for their individual cases with their 1031 transaction and subsequently are unable to complete their transaction. The rules are complex and somewhat convoluted, so I will do my best here to outline the overall process and special exceptions you need to be aware of.
Start and ending dates of a 1031 transaction
To start off with, the 1031 exchange begins on the earliest of the following:
1. the date the deed records, or
2. the date possession is transferred to the buyer,
And ends on the earlier of the following:
1. 180 days after it begins, or
2. the date the Exchanger’s tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.
Identification period
The identification period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the Exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason. A deadline that falls on Thanksgiving, Christmas, or New Year’s Day does not permit extension.
Exceptions
Identified replacement property that is destroyed by fire, flood, hurricane, etc. after expiration of the 45 day Identification Period does not entitle the Exchanger to identify a new property.
Mistakenly identifying condominium A, when condominium B was intended, does not permit a change in identification after the 45 day Identification Period expires. Failure to comply with these deadlines may result in a failed exchange.
IRS rules control the length of time that the replacement property must be held before it may either be sold or used to enter into a new tax deferred exchange. In highly appreciating markets, people may take the opportunity of selling their personal residence (where no capital gain is due below $250,000 for a single person or $500,000 for a married couple) and moving into a former rental property for a specified time period in order to turn it into their new personal residence, and thus avoid capital gains taxes.
Important timing rules
- Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
- The asset must be of like-kind. Real property must be exchanged for real property, although a broad definition of real estate applies and includes land, commercial property and residential property. Personal property must be exchanged for personal property. (There are some complicated rules surrounding this — for example, livestock of opposite sex are not considered like-kind property for the purpose of a 1031 exchange, and property outside the United States is not considered of "like-kind" with property in the United States.)
- The proceeds of the sale must be re-invested in a like kind asset within 180 days of the sale. Restrictions are imposed on the number of Replacement Properties which can be identified as potential Replacement Properties. More than one potential replacement property can be identified as long as you satisfy one of these rules:
- The Three-Property Rule - Any three properties regardless of their market values.
- The 95% Rule - Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.
- The 200% Rule - Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate Fair Market Value (FMV) of all of the exchanged properties as of the initial transfer date.
Why do many people miss these time limits for 1031 exchanges?
Frequently, the most difficult component of a 1031 exchange is identifying a replacement property within the first 45 days following the sale of the relinquished property. The IRS is strict in not allowing extensions.
A 1031 exchange is similar to a traditional IRA or 401(k) retirement plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until the holder begins to cash out of the retirement plan. The same principle holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deferred. Unlike the aforementioned retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.
An alternative to a 1031 exchange for someone who wants to defer capital gains tax, but who does not want to continue to hold property is a structured sale. This method offers both buyer and seller many benefits and is regarded as ideal for those looking to retire from or exit from the real estate or business market.
