Tax Mitigation Playbook: 1031 Replacement Property Rules

Financial Planning Dentist

Like-kind property is defined according to its nature or characteristics, not its quality or grade. This means that there is a broad range of exchangeable real properties. Vacant land can be exchanged for a commercial building, for example, or industrial property can be exchanged for residential. But you can’t exchange real estate for artwork, for example, since that does not meet the definition of like-kind. The property must be held for investment though, not resale or personal use. This usually implies a minimum of two years’ ownership.

To receive the full benefit of a 1031 exchange, your replacement property should be of equal or greater value. So you should expect to pay taxes on any elements that are not replaced (the Boot). 

You must identify a replacement property for the assets sold within 45 days and then conclude the exchange within 180 days. There are three rules that can be applied to define identification.

In addition to the timelines which are important in the 1031 process, there are some rules regarding the identification process that should be followed. As a rule, surrounding these rules, you will only be required to follow one of the below situations:

The 3-Property Rule

The 3-property rule states that the replacement property identification during the initial 45 days of the exchange can be made for up to three properties regardless of their total value.

So after the investor relinquishes their initial property, the taxpayer can identify and purchase up to three replacement properties that may suit their investment appetite going forward.

A qualified intermediary often requires that a taxpayer state how many replacement properties they intend to acquire to prevent common pitfalls surrounding the receipt of excess funds and the early release of funds.

The 200% Rule

If a taxpayer were to identify more than three properties, they could still have a valid exchange by following the 200% rule. The 200% rule states that a taxpayer may identify and close on numerous properties, so long as their combined fair market value does not exceed double the value of their relinquished property. 

Using the listing price is usually a safe way of determining a fair market value for a property.

The 95% Rule

If the taxpayer has overidentified both of the previous rules by identifying more than three properties, and their combined value being more than 200% of the relinquished property value, the 95% value comes into play. The 95% rule defines that identification can still be considered valid after breaking the first two rules if the taxpayer purchases through the exchange at least 95% of what they identified.

Keep the rules in mind and consult your Certified Financial Planner® and Exchange Manager for details regarding your exchange. 


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Tax Mitigation Playbook: What is a 1031?

A 1031 exchange, also known as a like-kind exchange or tax-deferred exchange, is where real property that is “held for productive use in a trade or business or investment” is sold and the proceeds from the sale are reinvested into a like-kind property intended for business or investment use, allowing the taxpayer, or seller, to defer the capital gains tax and depreciation recapture on the transaction. The property sold as part of a 1031 exchange is the Relinquished Property. The property purchased is the Replacement Property. The real property in a 1031 exchange must be like-kind; most real estate is like-kind to all other real estate. For example, an office building could be exchanged for a rental duplex, a retail shopping center could be exchanged for farmland, etc. During a 1031 exchange, neither the taxpayer nor an agent of the taxpayer can receive or control the funds from the sale of the property. If a taxpayer has direct or indirect access to the funds, a 1031 exchange is no longer valid. A qualified intermediary is used to hold the proceeds of the Relinquished Property sale until it is time to transfer those proceeds for the close of the Replacement property. To be eligible for a 1031 exchange the person or entity must be a US taxpaying identity. This includes individuals, partnerships, S-corporations, C-corporations, LLCs, and trusts. However, it is a requirement that the same taxpayer sells the relinquished property and purchases the replacement property for a valid exchange. 1031 exchanges were first authorized in 1921 because Congress saw the importance of people reinvesting in business assets and they wanted to encourage more of it. There have been changes and additions to the regulations that govern 1031 exchanges, and the most recent changes impacting real estate in a 1031 exchange were in 2001. The Complete Playbook

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