1031 Exchange Requirements

The Exchanger must have held the relinquished property for investment or for productive use in their trade or business and intend to do the same with the replacement property. A vacation home may qualify, if you've rented it out and have used it less that 14 days last year. Both rentals and vacant lots are investment property, and are eligible for an exchange so long as you select a replacement property to hold as an investment.

While no formal rule exists, your exchange could be challenged if you sell the replacement property shortly after the exchange. No specific time frame is defined, but many CPAs say you should hold replacement property for a year.

In order to defer all the capital gains taxes, You must buy 1031 replacement property of equal or greater value, with equal or greater debt, unless you bring in cash equal to the debt being paid off pertaining to the relinquished property. The equity must match. Before you enter into any exchange of real estate, you must first figure your adjusted basis.

Use our handy Capital Gains Tax Calculator

If the value of the replacement property is less or the net equity is less, you would be taxed on the greater of the trade down in value or equity, limited to the gain you would have recognized if the property simply had been sold for its fair market value.

The first timing requirement is that the property to be received in the exchange must be specifically identified within 45 days of closing on the relinquished property. To prove that identification has occurred, the taxpayer must designate the property in writing and must have proof that this writing was received within the time period. Property is appropriately identified only if it is specifically designated as replacement property and specifically described by reference to a legal description, a street address, or a distinguishable name.

The second timing requirement is that the identified replacement property must be received before the end of the exchange period. The exchange period begins on the date the property is transferred and ends on the date that is the earlier of 180 days after the date of the transfer or the due date of the relinquishing party's income tax return for the taxable year. This timing requirement must be strictly observed. In Christensen v. Commissioner,10 replacement property was received within 180 days of the transfer of the relinquished property but after the due date of the tax return of the party relinquishing the property. The court held that the exchange did not qualify for non recognition of gain or loss. The party argued that the due date of the return should be determined by including the time of an automatic extension for filing a tax return because the statute allows for the inclusion of extensions. The court, however, pointed out that the party had neither requested nor been granted an extension for filing a tax return, which placed the actual due date of the return prior to the time that the replacement property was received. The relinquishing party could have avoided the result in Christensen by simply requesting an automatic extension of the due date for the income tax return. It should be noted that replacement property can qualify as like-kind property even if it is not in existence or if it is being produced at the time it is identified.

Boot

Although it is not used in the Internal Revenue Code, the term “Boot” is commonly used in discussing the tax implications of a 1031 Exchange. Boot is an old English term meaning “Something given in addition to.” “Boot received” is the money or fair market value of “Other Property” received by the taxpayer in an exchange. Money includes all cash equivalents, debts, liabilities or mortgages of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject. “Other Property” is property that is non-like-kind, such as personal property, a promissory note from the buyer, a promise to perform work on the property, a business, etc.

There are many ways for a taxpayer to receive “Boot”, even inadvertently. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided.

The most common sources of boot include the following:

Cash boot taken from the exchange. This will usually be in the form of "Net cash received", or the difference between cash received from the sale of the relinquished property and cash paid to acquire the replacement property(ies). Net cash received can result when a taxpayer is "Trading down" in the exchange (i.e. the sale price of replacement property(ies) is less than that of the relinquished.)

Debt reduction boot which occurs when a taxpayer’s debt on replacement property is less than the debt which was on the exchange property. As is the case with cash boot, debt reduction boot can occur when a taxpayer is "Trading down" in the exchange.

Sale proceeds being used to pay non-qualified expenses. For example, service costs at closing which are not closing expenses. If proceeds from the sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer had received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their property to pay for the following: Non-transaction costs: i.e. Rent perorations, Utility escrow charges, Tenant damage deposits transferred to the buyer, and any other charges unrelated to the closing.

Excess borrowing to acquire replacement property. Borrowing more money than is necessary to close on replacement property will not result in the taxpayer receiving tax-free money from the closing. The funds from the loan will be the first to be applied toward the purchase. If the addition of exchange funds creates a surplus at the closing, all unused exchange funds will be returned to the Qualified Intermediary, presumably to be used to acquire more replacement property. Loan acquisition costs (origination fees and other fees related to acquiring the loan) with respect to the replacement property should be brought to the closing from the taxpayer’s personal funds. Taxpayers usually take the position that loan acquisition costs are being paid out of the proceeds of the loan. However, the IRS may take the position that these costs are being paid with Exchange Funds. This position is usually the position of the financing institution also. Unfortunately, at the present time there is no guidance from the IRS on this issue which is helpful.

REMEMBER, as a simplified "rule of thumb," you must trade equal or up in fair market value, and equal or up in equity, in order to have a fully tax deferred exchange. Keep this "rule of thumb" in mind when selecting your replacement property.

 The title to both the relinquished and replacement properties must be held by the exact same entity.

If the exchange fails because of failure to comply with the above procedure, or for any reason, your proceeds are refunded to you, and you are taxed as if the exchange never occurred.

Section 1031 authorizes direct deeding of the relinquished property by you to the buyer and direct deeding of the replacement property to you from the seller

The IRS does not consider construction or improvement to real property that you already own as "like kind" property. Neither does the IRS consider payment of a mortgage on real property that you already own as "like kind."

Replacement property may NOT be purchased from a related party (as defined by the IRS).