What You Need to Know About 1031 Exchange for Real Estate Property in Nevada
This article gives you an outline and the basic concepts of 1031 Exchange.
The concept of a 1031 exchange is fairly simple: the gain from the sale of your old property rolls over to your new property. As long as you continue to do 1031 exchanges on each successive property, the accumulated tax is postponed, until you ultimately decide it’s time to liquidate your investments. While the correct technical terms are “relinquished property” and “replacement property,” I found that using the terms “Old Property” and “New Property” is easier to understand. ‘Old’ and ‘New’ are more familiar words to describe the legal and technical terms.
Six basic requirements for a 1031 exchange
These are the same six things that the IRS looks at when they audit an exchange.
Rule #1 – Both the Old Property and the New Property must be held for investment or used in a trade or business.
It used to be that if you sold a duplex, you had to find someone that also had a duplex and the two of you swapped deeds. This was changed during the late 70s and early 80s by T.J. Starker in a series of Supreme Court cases (thereby giving rise to the term “Starker Exchange”).
In 1991 Congress rewrote Section 1031 and now you can sell your duplex and buy any other type of real estates, such as an office building, a warehouse, an apartment building or even bare land, as long as it too will be an investment property for you or used in your trade or business.
Section 1031 says that property held for resale does not qualify for an exchange. This means that developers and “fix ‘n flip” properties do not qualify for exchanges since the intent is resale rather than the holding for investment. There have been a number of court cases seeking to determine the dividing line between held for resale and held for investment. While the intent is a significant factor in determining the difference, the consensus of the exchange industry is that a holding period of a year and a day is a minimum time frame distinguishing between the two. One of the primary reasons for this is that it keeps taxpayers from turning short-term capital gains into long-term capital gains by doing an exchange.
Another important part of this requirement is that you cannot sell your Old Property to, or buy your New Property from, a related party. A “related party” is defined as your parents, grandparents, spouse, brothers & sisters, kids, and grandkids. There are similar rules for entities (e.g., corporations, partnerships, LLCs, etc.) owned by a related party.
A common question is whether the exchange property can be located outside of the United States. The answer is that if the Old Property is inside the U.S., then the New Property must also be inside the U.S. And if the Old Property is outside the U.S., the New Property must be outside as well. In other words, you can not cross U.S. borders with your 1031 exchange.
Rule #2 – 45 day identification requirement
From the day you close the sale of your Old Property, you have 45 days to complete a list of properties you want to buy. Typically this list will have 3 properties or less on it. This is because you can list up to three properties with no limitations. For example, if Mr. Smith, Investor, sold their Old Property for $100,000, they could list three properties for $10,000,000 each (a total of thirty million) because there are no limitations.
If your list has more than three properties, then the combined purchase price of all of the properties on the list can not exceed twice the selling price of the Old Property. This is called the 200% rule. Going back to Mr. Smith, if he lists more than three properties on his list (it does not matter if the list has 4 or 400 properties), then the combined purchase price of all the properties can not exceed $200,000 (i.e. twice the Old Property selling price of $100,000). If you exceed the 200% limit, your whole exchange is disallowed. The common-sense rule here is to keep your list to three properties or less.
The 45 days are calendar days. That means that if the 45th day falls on a Saturday or Sunday, or a holiday such as the 4th of July, or New Years Day – that is the final day: you must have your list completed by midnight on that day – there are no exceptions or extensions! If the IRS can prove that you changed your list after the 45th day, you and your Qualified Intermediary will go to prison. That is the truth.
The list is given to the Qualified Intermediary whose job it is to receive the list on behalf of the IRS. See Rule #4.
The list has to be prepared in a way that an IRS agent could take the list and go directly to the door of the property. You want to list a property as “123 Main Street, Anywhere, USA.” Identification such as ” an office building on Main Street” won’t work. In other words, the 45-day list must be specific and in writing.
Rule #3 – 180-day purchase requirement
This rule is pretty simple: again from the day of closing, you have 180 days to close the purchase of what you are going to buy, and what you buy has to be on your 45-day list. The 45 and 180-day requirements run concurrently meaning that when the 45 days are up, you only have 135 days left to close. And like the 45-day identification requirement, there are no extensions.
Closed means that the risk of loss has to pass to you. In other words, the title has to pass to you before the 180th day.
Rule #4 – Qualified Intermediary requirement
You can not touch the money in between the sale of your Old Property and the purchase of your New Property. By law, you have to use an independent third party to handle the exchange.
The function of the Intermediary is to prepare the documents required by the IRS both at the time of the sale of the Old Property and at the time of the purchase of the New Property and to hold the proceeds from the sale until the purchase of the New Property.
If the documents are not prepared correctly, the IRS will disallow the exchange. Yes, they do disallow exchanges for improper documents. Remember, the IRS loses a ton of tax to Section 1031, so they check to make sure that the documents are perfectly correct.
Section 1031 does not define who can be a Qualified Intermediary – it defines who can NOT be an Intermediary (in other words – who is disqualified). Included on the list of disqualified persons: the taxpayer’s attorney and CPA, their realtor, any relative, any employee, and any business associate. This means that the Intermediary needs to be a completely independent party.
None of the 50 states, or the Federal Government, regulates Qualified Intermediaries. This means that a convicted felon could be an Intermediary and hold clients’ money. For this reason, it is prudent to use caution in selecting an Intermediary. More importantly of all, you want to make sure that they are bonded.
Rule #5 – Title Requirement
Any entity, such as corporations, trusts, partnerships, LLCs, etc. may do an exchange. They all have the same rule: the tax return that holds title to the Old Property must be the same tax return that takes title to the New Property.
For example, if Mr. Smith is married and he files a joint return and the couple sells the Old Property, then one spouse may not buy a replacement property in his/her name only.
Likewise, if a partnership, or LLC, owns the Old Property, then only one tax return (i.e., the partnerships) owns the property even though the partnership has many partners. If the partnership sells the property, then the partners may not do an exchange – only the partnership may. In these situations, it comes down to “all or none” when the partnership is considering an exchange.
A solution that most attorneys devise to the problem of partners wanting to go different directions is to liquidate the partnership or LLC and give each of the partners a tenant-in-common interest in lieu of their partnership interest. The problem with this solution is the holding period requirement of one year and a day in Rule #1. In other words, if you dissolve the partnership today and close the sale of the property next week, each of the ‘new’ owners now has a one week holding period for their interest: meaning that they held it for resale and not for investment, which will result in the exchange being disallowed.
Can any of the partners sell their partnership interest and do a 1031 exchange? No – because they are not selling real estate, they are selling a partnership interest and the IRS does not allow exchanges of partnership interests.
Rule #6 – Reinvestment Targets
To defer all of your capital gains tax, you must buy a property of equal or higher value than the one you sold, and you must reinvest all of the cash proceeds from the sale. It sounds complicated but it’s not.
Let’s assume the following set of facts:
- The sale price of Old Property $100,000
- Debts paid at closing 40,000
- Cash to Intermediary 60,000
Example #1: Fred & Sue sell their Old Property for $100,000. The mortgage on the property is paid off at closing and the balance of $60,000 is transferred to the Intermediary. If they buy their New property for $90,000, they’ve bought down by $10,000. The buy down does not kill their exchange, but the difference (between the Old sales price and the New purchase price) of $10,000 is taxable. The IRS calls this taxable amount “boot.”
Example #2: Same facts, but instead of buying the New Property for $90,000, they decide to buy a New Property for $150,000 for which they are obtaining a loan for $100,000. This means that they will only use $50,000 of the $60,000 proceeds that the Intermediary is holding. The $10,000 excess is also boot and is taxable.
In both of the examples above, the entire $10,000 is taxable. In a 1031 exchange, the gain is taxed first. Where you have a boot situation, the boot is taxable to the extent of the lesser of the boot or the entire gain on the transaction.
So let me restate this rule for you again: In order to pay zero tax, you have to do two things: you have to buy a property equal or higher in value than the one you sold, and you have to reinvest all of your cash. Now that we’ve worked through it, the rule should not seem so complicated.
Notice that you do not have to have debt on the New Property equal to or greater than, the debt that was paid off on the Old Property.