Defer Capital Gains on Real Estate
1031 exchanges are extremely useful in deferring capital gains taxes on the sale of real estate, but they are complicated. Importantly, the IRS will give absolutely no leeway on the timeline.
The 45 day Identification Window
Once you have completed all the legalities for the sale of the original property, and you have relinquished ownership, the clock starts ticking. You have 45 days to invest those funds into another property. At the point of the original property sale, funds from the sale are sent directly from escrow to a pre-selected independent third party, known as the qualified intermediary (QI) or the 1031 exchange facilitator. These professionals know to place the funds in an independent, FDIC-insured account. Commingling the funds with those of any other investors must never be done. These funds will stay in their designated account until required to purchase the replacement property.
Did the 45th day fall on a Sunday or a holiday? Did you get hit by a bus? It doesn’t matter. It matters to you, but not to the IRS! If you haven’t identified the property you plan to purchase as part of the exchange process, then you are no longer eligible. And those precious capital gains will, in fact, be taxed.
The 3 Property Rule
The good news is that you don’t have to pick just one perfect or almost perfect piece of property. You are able to choose three (but no more than three), as candidates for the exchange. This gives you at least some options while you follow through with your due diligence and the final decision.
For some inventors, the choice is narrowed down to just one of the three properties. However, it’s also possible for you to invest in all three of the designated replacement properties. If you find another property of interest outside of that 45 day window, you are free to invest in it. But any funds from the original property invested in anything besides the three properties originally identified within the 45 day window will be charged capital gains taxes.
The 200% Rule
Because this exchange is not simple, it comes with a lot more rules. Another very important rule is the 200% Rule. This means that the aggregate value of the properties you invest in with funds from the 1031 exchange cannot exceed 200% of the fair market value of the relinquished property.
An investor who sold a property for $1.5 million, can invest in any one-to-three designated properties only as long as their total value does not exceed 43 million. The IRS frowns (and outright denies) exceeding that limit and views it as having failed to identify a suitable investment replacement property.
The 95% Rule - an Exception
There is an exception to both the 200% rule and the 3 properties rule, however. Investors can legally choose more than three identified properties but also are allowed to exceed a total of 200% of the fair market value of the relinquished property, if (and only if!) they can successfully close on 95% of the value of each of the replacement properties in question.
Any Leeway?
There is no leeway in following to the letter the requirements surrounding the 45- and 180-day deadlines in a 1031 exchange. Only in the event of a Presidentially declared disaster or state of emergency will any variance from the deadline be granted. If the regulations aren't strictly followed, an investor could be facing a whopping capital gains tax.
Follow the timelines, however, and capital gains taxes can be deferred indefinitely, possibly even forever.
Related Links:
Articles:
How to be in real estate without being in real estate
Qualified Opportunity Zones: What you need to know
The 45-Day Window: How not to make a huge mistake with 1031 exchange
Navigating a 1031 Exchange With Mortgaged Property
These tax deferral tools are complicated and require significant expertise to realize the benefits and avoid the pitfalls. Planning Network Partners is dedicated to examining this and other opportunities as part of a larger picture of your whole financial health.
Contact Us for expert assistance.