We assume you to be aware of the term ‘1031 exchange’. In case you aren’t, a 1031 exchange is a real estate exchange process that allows investors to differ capital gains taxes. Generally, on exchanging one property for another ‘like-kind’ property, an investor gets the benefit of deferring capital gains taxes under Section 1031 of IRC. So, at the end of an exchange, an investor doesn’t require to pay any capital gains tax. Not to mention, 1031 Exchange isn’t tax-free; it only allows investors to postpone capital gains taxes temporarily.

What most real estate investors struggle to figure out is how Section 1031 allows tax deferment? Or how a 1031 exchange works? At first, you need to decide whether you want to sell your old property or exchange it for another asset. In the case of property exchange, the investor must consult a Qualified Intermediary before selling the relinquished property. The Qualified Intermediary is the one who sells the relinquished property on behalf of the investor. In fact, the 1031 expert or Qualified Intermediary plays a major role in a 1031 exchange and completes the entire exchange. The reason why tax deferment is possible in a 1031 exchange is that the proceeds received after selling the old property are reinvested on replacement properties. Hence, no taxable income is recognized at the end of the exchange.

What troubles investors in 1031 exchanges, is time limit. A 1031 exchange is time-driven, and there are deadlines within which an exchange must end, or else it will no longer be valid.

45 Days Period – When you sell the old property, you get 45 days to identify one or more potential replacement properties. This is the first deadline and is known as the ‘identification period.’ The identification period starts the day relinquished property is sold. You must submit identification, consisting of the street address, to the IRS on or before Day 45. In case an investor fails to send the written identification of the replacement property within 45 days, no extension shall be given as per the rules. The identification period may pose a challenge to some investors, as sometimes, identifying a replacement property could take more time. Therefore, it is recommended to involve a Qualified Intermediary in a 1031 exchange as early as possible.

180 Days limit – Another deadline that may bother investors in 1031 exchanges is the time limit of 180 days, which is given to acquire the identified replacement property or properties. Calculating these 180 days can be confusing as it also includes the identification period. In simple terms, investors get 180 days in total to complete an exchange. The first 45 days are given to identify the replacement property that must be acquired in the next 135 days. If you fail to complete your transaction before the deadline, your 1031 exchange will no longer be valid. Moreover, the initial 45 days and the total 180 days are normal calendar days and not business days. Therefore, it doesn’t matter whether the 45th day is a holiday or a business day; the property’s identification must be completed on or before that.

Isn’t the query that when and how these deadlines became effective bothering you? It’s normal and not ambitious if such questions arise in an investor’s mind. After all, it’s good to know your investment inside out.

Time limitation was imposed on 1031 exchanges after an exchange done by the Starker Family, the principal investor, in the case, was put to question by the IRS. As reported, the Starker Family had acquired the replacement property after five years of closing on the sale of the relinquished property. Therefore, the IRS denied to consider it a 1031 exchange and asked the Starker Family to pay tax on the profit. In response, the Starker Family moved to the court, where the judgment went in their favor. IRS realized that imposing deadlines on 1031 exchanges was the only way to guarantee an exchange within a limited time-frame. Later, an ‘identification period’ of 45 days was included in 1031 exchanges, along with a total of 180 days for sealing the exchange.

1031 Exchanges, not only have time limitations, but the number of properties an investor can identify is also limited. However, there is a possibility that an investor may want to identify another property after submitting the written identification to 1031 Corp. They may be able to do that, but with the following limitations:

1. The Three-Property Rule allows an investor to identify up to three replacement properties irrespective of their combined Fair Market Value. There is only one requirement that the investor must buy at least one of the identified properties.

2. The 200% Rule allows an investor to identify any number of replacement properties as long as the Fair Market Value of all the identified replacement properties doesn’t exceed the Fair Market Value of the relinquished property.

3. The 95% Rule allows an investor to identify any number of replacement properties as long as the total price of the property acquired is at least 95% of the value of all identified replacement properties.

As long as you follow any of the rules mentioned above, you can make changes related to the identification of the replacement property. However, any such change must be completed inside the identification period, that is, within 45 days from closing on the sale of the relinquished property. 1031 Exchanges require the guidance of experienced tax consultants, and you mustn’t hesitate to consult one. Since a Qualified Intermediary is responsible for exchanging properties on behalf of the parties involved in a 1031 exchange, investors don’t need to sweat in searching or acquiring replacement properties as the Qualified Intermediaries manage everything.

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