1031 Exchange Rules and Exceptions

Understanding 1031 exchange rules, prior to making an exchange, is important to avoid legal and tax problems. There are many benefits to 1031, or like kind exchanges. One of the biggest benefits is the ability to defer any taxes on the gains. In order to benefit from the tax advantages, you need to know what the rules and exceptions are, so that you can apply them correctly. Here are the major ones you should be aware of:

Rule # 1 - Time Limit to Identify Replacement Property

According the Internal Revenue Service (IRS), you have 45 days to identify replacement property after selling relinquished property. You must have closed your transaction in the 45 days. The written document must include a legal description of the relinquished property, which may be more than one property. When calculating the days, weekends and holidays are included.

Rule # 2 - Time Limit to Exchange Property

There's also a deadline under 1031 exchange rules for when you must exchange the property. The main rule is that you have to exchange the property the earliest of these two dates:

  • No more than 180 days after you sell the relinquished property
  • Due date of the income tax return that would include filings on the relinquished property sale, including filing extensions

If this time limit is not met, the property won't qualify as a 1031 exchange, and the rules for taxes on capital gain on the sale of non-exchange property will apply.

Rule #3 - Receipt of Cash Prior to Exchange May Disqualify the Property

It’s important to work with a qualified intermediary to hold any cash in escrow prior to the exchange. If you personally receive, the 1031 exchange rules require you to pay taxes on the gains. You’re not allowed to choose an intermediary who has worked for you, such as a realtor or attorney.

Exception # 1 - Primary Residence Does Not Qualify

Many types of property can qualify for a 1031 exchange, but the exception is a primary residence. That includes a second home as well. You will have to pay taxes on the gain if a primary residence is either the relinquished or replacement property. Investment property, or property that is used in connection with a business is qualified property under 1031 exchange rules.

Exception # 2 - Like Kind Rules Differ for Foreign Property

In the United States, you can exchange any type of qualified real estate property for another. The properties don't have to be identical. For example, you could exchange a farm in a rural area for an apartment building in the city. The exception to this is when you're dealing with property in the United States and property in another country. The property is not considered like-kind, and the exchange cannot qualify for a 1031 exchange.

An experienced real estate attorney can help you to avoid the pitfalls in the 1031 exchange rules. You do not want to end up paying taxes on gains if your expectations are to defer it for a later date.

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