21 Oct Key 1031 Exchange Rules That You Must Know
1. Property Identification
Post closing of the first property, the Exchangor has 45 days to identify to either the accommodator or the closing entity the addresses of the potential replacement properties. Below are some 1031 exchange rules you must follow:
- 3 property rule – can identify any three properties regardless of value.
- 200% rule – can identify four or more properties as long as the value doesn’t exceed 200 percent percent of the property sold.
- 95% exception rule – if the value exceeds 200 percent, then 95 percent of what is identified must be purchased.
Within 180 calendar days following the closing of the first property or extension of the Exchangor’s tax return, the property must be purchased. This one of several 1031 exchange rules that can’t be modified.
3. Trading Up
The net market value and equity of the property sold must be equal to or greater in the replacement property to defer 100 percent of the tax. Otherwise, the Exchangor needs to pay tax on the difference. Debt and equity in the replacement property must be equal to or greater than the debt and equity in the relinquished property. Additional equity in the replacement property offsets debt. Additional debt does not offset equity.
Here is a great example of a 1031 Exchange
To understand the powerful protection a 1031 exchange offers, consider the following example:
- An investor has a $300,000 capital gain and incurs a tax liability of approximately $100,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $200,000 remains to reinvest in another property.
- Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $800,000 new property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire $300,000 of equity in the purchase of $1,200,000 in real estate, assuming the same down payment and loan-to-value ratios.