You might have read or heard about Section 1031 of IRC. A unique investment strategy that lets you defer capital gains tax on the sale of an investment property. Generally, on selling a property, the property owner is required to pay taxes imposed on their proceeds. However, a 1031 Exchange offers relaxation of capital gains taxes for the time being. Not to mention, exchanging properties under 1031 Exchange is qualified for tax deferment, but it’s not tax-free.
One of the things that investors must pay special attention to in a 1031 Exchange is the time limit or deadlines. The Internal Revenue System (IRS) is stringent when it comes to the time limit in a 1031 Exchange. The entire process of a 1031 Exchange must be completed within the time limit set up by the IRS, or else the exchange will no longer be valid. So, what are these deadlines?
1031 Exchange Deadlines –
Deadlines were attached to 1031 Exchanges after a case filed by the Starker family in 1967 against the IRS. The dispute between IRS and the Starker family had taken place on the issue of tax deferment when the later had acquired a replacement property after five years of closing on the sale of their relinquished property. As a result, the IRS questioned the exchange and ordered the Starker family to pay taxes on the profit they had received. However, the Starker family filed a case against IRS in the district court where the court’s judgment went in their favor. Since then, ‘Starker Exchange’ has become a synonym for delayed exchange. IRS learned that time could play a big role in 1031 Exchanges, and the entire exchange process needs to be time driven. Consequently, deadlines became applicable to every 1031 exchange.
45 days time period – The first deadline that applies to a 1031 exchange is a time period of 45 days given upon the sale of the relinquished property. As per the rules, a taxpayer gets a time limit of 45 days to identify the potential replacement property, failing to which shall immediately disqualify the exchange. This period of time is known as the ‘Identification Period.’ Generally, these 45 days starts after the sale of the relinquished property. So, the day a taxpayer closes on the sale of the relinquished property, that’s ‘Day Zero.’
If a taxpayer fails to submit a written identification of the potential replacement property on or before the 45th day, they shouldn’t expect an extension from IRS as they don’t give any. However, as there is scope for exceptions anywhere, IRS does give extensions on just two occasions – either in case of a natural disaster or if any of the party is serving the army in a combat zone. Didn’t we mention, exceptions do exist. There is a rule for sending the identification of the property as well.
A taxpayer should write the unambiguous address of the potential replacement property or properties, in case there are a couple, and send it to the Qualified Intermediary on or before the midnight of the 45th day. So, a 1031 exchange can disqualify even when the taxpayer fails to send the correct identification of the replacement property. Upon identifying the replacement property within the time limit, the next job is to acquire the potential replacement property within the deadline of 180 days.
180 days time period – Another deadline that is applicable to 1031 exchanges is the time limit of 180 days given to acquire the replacement property. Basically, the taxpayer gets a time limit of 180 days, upon closing on the sale of the relinquished property, to acquire the identified replacement property. These 180 days begin from ‘Day Zero’ and not from the 45th day. Many investors tend to get confused about calculating deadlines. Therefore, in simple words, the taxpayer gets 180 days in total to close the exchange. The time starts from the sale of the relinquished property, and the first 45 days are specially given to identify the replacement property. Whereas, the taxpayer must acquire the identified replacement property in the next 135 days, or else the exchange will no longer be valid.
Property Rules In 1031 Exchanges –
There are solid chances of you finding more than one potential replacement property, and you may want to change your mind even after identifying your replacement property. Well, it’s certainly not impossible to identify more than one replacement property. However, there are a few conditions applied to it. A taxpayer can identify more than one replacement property if the following rules are followed:
- The Three-Property Rule: A taxpayer is allowed to identify up to three potential replacement properties, and not all of them need to be purchased. However, the taxpayer must buy one of the three identified replacement properties. The price of the replacement property must be equal to that of the relinquished property to qualify for a 1031 exchange.
- The 200% Rule: It states that a taxpayer can buy any number of replacement properties so long as the Fair Market Value of all the replacement properties doesn’t exceed 200% of the Fair Market Value of the relinquished property.
- The 95% Rule: This rule allows the taxpayer to buy any number of replacement properties if the cost price of the replacement property acquired at the end of the exchange is at least 95% of the total price of the identified replacement properties.
These few rules and requirements are quite significant in determining your eligibility for a 1031 Exchange, particularly the deadlines. Deadlines for 1031 Exchanges can’t be negotiated under any circumstances. Therefore, a taxpayer must complete their 1031 exchange on time or else they will lose the advantage of deferring capital gains taxes. The duration of 180 days may seem enough at first. However, one mustn’t forget that finding a replacement property can be a very long process, and finding a ‘like-kind’ replacement property definitely requires more effort. A taxpayer must seek help from a Qualified Intermediary. For one reason, it is mandatory in a 1031 exchange, and secondly, doing so will also reduce the burden from the taxpayer’s shoulder.