Investment advisor explains rules and timelines of a Section 1031 Exchange
A Section 1031 Exchange is the most widely-used, tax-saving strategy when selling appreciated farm or ranch land. This article outlines some basic rules and timelines to follow.
Future articles will discuss more practical examples of how to use a Section 1031 Exchange.
Section 1031 of the Internal Revenue Code states a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property, a process known as a Section 1031 Exchange.
To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business or for investment. The properties exchanged must be of “like kind,” i.e., of the same nature or character, even if they differ in grade or quality.
The “like kind” definition confuses some people. “Like kind” does not mean someone needs to exchange land for land. One can exchange land for other types of investment property, such as rental houses or commercial buildings.
Section 1031 Exchange timelines and rules
The majority of Section 1031 Exchanges are delayed or Starker exchanges, named for the first tax case to allow them. To perform a delayed exchange, one needs a qualified intermediary middleman, who holds the cash after they sell their property in an escrow account and use it to purchase the replacement property.
There are two key timing rules one must observe in a delayed exchange.
The 45-day rule
Once the sale of relinquished property closes, money is wired from a title company to a 1031 intermediary. If a person takes possession of the cash, the exchange is void, and they will have to pay taxes.
Within 45 days of closing on relinquished property, one must designate the replacement property in writing to the 1031 intermediary, specifying the property or properties they wish to acquire.
The 180-day rule
The second timing rule in a delayed exchange relates to closing. A person must close on new property within 180 days of the sale of the old property.
The two time periods run concurrently, which means an individual must start counting when the sale of their property closes. For example, if they designate a replacement property exactly 45 days later, they will have just 135 days left to close on it.
Property identification rules
There are three property identification rules – the three-property rule, the 200 percent rule and the 95 percent rule.
The three-property rule
Using this rule, an investor may identify up to three potential replacement properties, regardless of their total market value and acquire any or all of them.
The 200 percent rule
Under this rule, an investor may identify any number of potential replacement properties if their total value does not exceed 200 percent of the relinquished property’s total value by the end of the identification period. The investor may then acquire any or all of the properties as desired.
The 95 percent rule
An investor may identify any number of potential replacement properties as desired, regardless of their value, if the investor acquires 95 percent of the total market value of all properties identified.
It’s also possible to buy replacement property before selling a property and still qualify for a Section 1031 Exchange. In this case, the same 45 and 180-day timelines still apply.
To qualify for a reverse exchange, one must transfer the new property to an Exchange Accommodation Titleholder (EAT), identify a property for exchange within 45 days and then complete the transaction within 180 days after the replacement property was bought. Reverse exchanges cost more to perform than a regular delayed exchange.
Section 1031 Exchange tax implications
A landowner may have cash left over after the intermediary acquires replacement property. If so, the intermediary will pay the money to the landowner at the end of the 180 days. This cash, known as “boot,” will be taxed as partial sales proceeds from the sale of the property, generally as a capital gain.
Replacing debt on relinquished property
If a person wishes to defer all taxes on the sale of property with a Section 1031 Exchange, they must replace all of the debt with their replacement property. If they don’t receive cash back but their liability goes down, this will also be treated as income, just like cash.
This is referred to as “debt-relief boot,” and individuals will be taxed on this amount of money. One way to remember this is one must stay even or go up in equity and debt with their replacement property.
Chris Nolt is an independent registered investment advisor and the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC, sister companies dedicated to working with families around the country who are selling a farm or ranch and transitioning into retirement. To order a copy of Chris’s new book “Financial Strategies for Selling a Farm or Ranch,” visit amazon.com or call Chris at 800-517-1031. For more information, visit solidrockproperty.com and solidrockwealth.com.