For recognizing potential like-kind replacement properties in your 1031 exchange transaction, there are very specific identification requirements. When you identify these like-kind replacement properties, they do not need to be under any contract or escrow. However to take the advantage of this wealth preserving and income producing benefit, certain conditions must be met. Here are the rules for 1031 exchange.
REAL PROPERTY USE
For exchanging any type of real estate, both your old and new properties must qualify the test of investment or business use.
45-DAY IDENTIFICATION PERIOD
180-DAY EXCHANGE PERIOD
The basis for the 1031 states that the individual has 180 days from the date of selling his property to accept the newly acquired property.
The “Exchange Period” under 1031 is the period within which an individual receives the replacement property for his sold relinquished property. This exchange period ends at 180 days after the due date for the person’s tax return for the taxable year in which the transfer of the relinquished property occurred or the date on which the person transfers the surrendered property, whichever is earlier. A word of expert advice wait until the deadline ends. Do it as early as you can. Many careless investors assume that they can wait until the last minute to purchase the new property after seeing their language referring to the due date for their tax return. For instance, if an individual sells their property in June, the deadline for acquiring a new property would fall before his tax return in the spring of the same year.
Identification Rules And Exceptions
1031 EXCHANGE ID RULES
You must adhere to at least one of these given identification rules or exceptions while executing the classification of your like-kind replacement properties:
It is a safe option to think of a replacement property in mind and purchase the agreement set up before opting to start the 1031 process. “The three property rule” states that the dealer of the replacement or abandoned property can identify up to 3 replacement properties, despite their value.
THE 3 PROPERTY IDENTIFICATION RULE
The vast majority of Investors today are using the three (3) property identification rule because this rule limits the total number of like-kind replacement properties that you can identify with your three (3) potential like-kind replacement properties. As part of your 1031 exchange, investors can get all of the three identified like-kind replacement properties, but most Investors only acquire one of the three defined properties. Usually, the second and third specified properties are kept as a backup in case they are not able to get the first like-kind replacement property.
If you are trying to broaden your investment portfolio and wish to identify more than three like-kind replacement properties, you can skip this three property identification rule and use the 200% of Fair Market Value Rule.
200% OF FAIR MARKET VALUE IDENTIFICATION RULE
You are allowed to identify more than three like-kind replacement properties until and unless the total fair market value of all your identified like-kind replacement properties does not exceed 200% of the total net sales value of your acquired property or properties sold in your 1031 exchange. You can choose any number of like-kind replacement properties. The restriction is only for the total identified value.
For example, if you sold your relinquished property(ies) for $3,000,000, then you can identify as many like-kind replacement properties as you want as long as the aggregate value of the identified like-kind replacement properties does not exceed $6,000,000 (200% of $3,000,000).
95% IDENTIFICATION EXCEPTION
The third and the last rule is the 95% rule, wherein if you identify more than three properties and their total fair market value exceeds 200% of the value of what was sold, the transaction may still be valid if 95 % of the entire cost of all properties on the list are acquired. For example, you have properties worth $ 200,000 on your list, and then you need to purchase at least $190,000 of them.
With Solid Investments, you can locate a like-kind property for a 1031 exchange, and we assure you a steady and successful transaction.
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1031 EXCHANGE RULES FAQ
HANDLING TAX BASIS IN A 1031 EXCHANGE
A section in which we get a bunch of inquiries, is about the right approach or handling of basis in a 1031 exchange. Various questions asked are: “What happens to the basis, when I send my old property?”, “What are the updates of the reduction already taken by me?”, “Will 1031 exchange help me in freshening up my depreciated old property?”, “If I think of buying the New Property worth $100,000, can I depreciate the whole $100,000?” Such questions compare with what happens to the basis of the property when you do a 1031 exchange.
The initial step that determines the basis of your New Property is the basis of your Old Property. Let us explain to you with an example. Suppose Alice and Ben are selling their duplex which they bought in 1994 for $50,000 and they have taken $10,000 as depreciation on the duplex since they bought it. Their tax basis in the duplex is $40,000 ($50,000 minus $10,000). They are selling it for $100,000 and have found a condominium to buy as their replacement property as per their 1031 exchange. What is the basis in their condominium? And how is the discount handled on the condominium?
You need to notice that they bought the condominium for the same price at which they sold their duplex. This is a significant fact because the purchase price of the New Property is one of the basic facts that affect this answer. The answer is they “bought for equal,” the basis in the new condominium is $40,000 – the same as it was for the old duplex. In a 1031 exchange, the basis rolls forward from the Old Property (the duplex) to the New (the condominium). What’s more important, on their future reduction schedules is the purchase date for the condominium is 1994 (it is the date of the original purchase of the duplex), and the reduction schedule carries over as if they were still deteriorating the duplex.
The only reason for this is that according to IRS, you still own the original property, except that the address and legal description of the property are now that of the condominium as per the 1031 exchange. In a 1031 exchange, the purchase date, holding period and depreciation schedule continue unchanged by the exchange; the basis in the condominium is the same as it was for the duplex.
Now, let’s change our presumptions and see what happens if instead of buying the condominium for the same price they sold the duplex, they would have bought an office building for $160,000. In other words, they got up by $60,000. Their basis in the office is now $90,000 which is the order of the “rollover basis” of $40,000 from the duplex and the $60,000 buy up from the office. Their reduction schedule shows the continuous depreciation of the duplex (as if they still owned it) and the purchase of the office portion as of the date they closed on the office purchase.
What happens if they thought to buy down? Instead of the office building, let’s say Alice and Ben buy a rental house, for $80,000. They sold the duplex for $100,000 and now they are buying down to $80,000. As the basis always rolls over, so their basis in the rental house is $40,000 – the same as of the duplex. Because they bought down, the amount of the buy down ($20,000) is taxable. That’s why we always say that “the gain comes first in a 1031 exchange.”