If you're about to embark on the 1031 exchange process, or are in the process of an exchange, you'll find that the 45-day identification period goes by far too fast.
To help you navigate the identification process and understand which properties are eligible for 1031 exchange reinvestment, the IRS has laid out specific guidelines on which properties you can consider.
First and foremost, your primary residence cannot be used for 1031 exchange reinvestment (unless this specific scenario applies to you). Properties that are eligible for 1031 exchange reinvestment must be "like-kind," meaning the property is used for productive use in a trade, business, or investment.
There are several details to keep in mind when beginning the process of identifying a 1031 exchange property:
1. Keep your options open
Think broadly when considering a property for your 1031 exchange. Fortunately, the IRS doesn't consider "like-kind property" to be nearly as restrictive as it sounds. You can choose from apartment buildings, industrial parks, office space, retail shopping centers and malls, single-family home rentals, and more.
Each has unique advantages and disadvantages. From an investment standpoint, they may seem like they’re from different universes. But when it comes to like-kind exchanges, there's no requirement that an apartment rental investment be exchanged for another apartment rental. Instead, an apartment building can be exchanged for a single-family home and raw land can be exchanged for an office building.
You may have your sights set on a particular property type when you enter the exchange, but this is a great opportunity to broaden your horizons and experience owning a different type of property to diversify your portfolio.
Although there's a lot of flexibility with the "like-kind" structure, it's important to note that real property held in the United States must be exchanged for property also held in the United States.
2. Hire a Qualified Intermediary
You only have 45 days to identify a replacement property, so you want to make sure there aren't any hiccups during that restricted timeline. To help your 1031 exchange run smoothly, you must hire a Qualified Intermediary who's responsible for holding and protecting the sale proceeds throughout the exchange. You, as the investor, aren't allowed to access the funds.
Qualified Intermediaries play a number of essential roles throughout the process, but they also offer a strong support system during the process and will ensure you comply with IRS guidelines.
3. Hire a commercial real estate broker
In addition to working with a Qualified Intermediary, you can also hire a broker who specializes in commercial real estate. He or she will work on your behalf to move the process along quickly and ensure that you don't miss any deadlines.
If you're interested in finding 1031-eligible properties on your own, companies such as LoopNet, Post 1031, 1031Gateway.com, and 1031 Crowdfunding are great places to start.
4. Stick with properties of equal or higher value to avoid capital gains tax
You can identify a property of lesser value than your current property, but you'll be responsible for paying capital gains tax on the difference. If you sell a property for $2,000,000 and identify one listed for $1,500,000, you'll pay capital gains tax on the $500,000 difference (which is referred to as "boot").
To avoid paying capital gains tax altogether, identify a property with a net market value that's equal to or greater than the value of the property sold.
5. You can identify more than one property
To help mitigate the risk of a purchase not closing, you can designate more than one property as a replacement. These additional properties act as a reserve should the desired transaction fail to close.
You can identify up to three properties for 1031 exchange reinvestment. Although you may identify two or three properties, you don't have to commit to buying them within the 180-day timeframe. You can close on one or two, but make sure that the value of the properties is equal to or greater than the property you're selling to avoid capital gains tax.
6. You can even identify more than three properties
You can identify three properties if the value of the targeted properties doesn't exceed 200% of the value of the property you just sold.
For example, if you sell a $1,000,000 property, you can identify more than three properties as long as they don't exceed $2,000,000 in value. If you identify more than three properties, you must close on at least 95% of the combined value of the identified properties within the 180-day closing period. If you fail to do so, you'll be liable for capital gains tax.
The 1031 exchange is a tool used by savvy real estate investors to take full advantage of the tax, leverage, and cash flow benefits that investment real estate provides.
Because the execution and nuances of 1031 exchanges can get quite complex, investors new to real estate or the like-kind exchange process should contact qualified tax and real estate professionals to be sure an exchange is properly executed.