Understanding The Rules And Requirements Of A 1031 Exchange
A 1031 exchange is a distinct type of property transaction that helps you defer the taxes on a transfer of assets. There are strict 1031 exchange rules, and you must follow them closely to avoid unintentionally realizing a potentially major tax event. Here are the key 1031 exchange requirements.
Whenever someone uses 1031 for a transaction, they need to participate in a like-kind exchange. This means that the properties involved must be of similar legal dispositions. At first, this may sound strict. However, like-kind merely means that the properties have to serve the same purpose as a business asset. You could exchange a grocery store for a student housing complex, for example, and this would satisfy the 1032 exchange requirements. Generally, a property meets the like-kind requirement if a reasonable person would classify it as an investment property.
A qualified intermediary must facilitate the exchange. The QI acts a bit like an escrow, but the job is legally different. The intermediary holds onto the proceeds of one sale and transfers them to the seller of a replacement property. Not only does this protect everyone's interests in the exchange, but the QI also is responsible for only making the exchange once they're sure it meets the legal requirements for a 1031 deal.
Notably, the QI has to handle all of the money. If you take possession of the money or receive it in an account, it ceases to be an exchange for tax purposes. Instead, that money becomes income and is immediately taxable for the current tax year.
Statutory Time Limits
If you wish to conduct a 1031 exchange, you have over a month to identify a list of properties. Each property needs to meet the 1031 exchange rules to serve as a replacement for the one that you're selling. If you identify a property that you'd like to exchange, you must notify the QI in writing so they can verify if it meets the requirements.
There is also a second statutory time limit. Once you've sold the first property, you must complete an exchange for a replacement within a few months. There are some cases where the sale must finish sooner if you have a tax return due.
Notifying Tax Agencies
You must notify tax authorities about the exchange, including information about the two properties, the QI, and any money involved. Likewise, you have to explain the disposition of any profits from the sale. Most people reinvest the profits into the replacement property, thus eliminating or limiting the taxable income from the deal.