In a 1031 Exchange, real estate investors can defer capital gains taxes on the profitable sale of an investment property as long as they “exchange” the sale proceeds into a new property that is considered to be “like kind.” For savvy investors, there are obvious tax advantages to this type of “like kind exchange“, but there are also a series of rules that must be followed to achieve full tax deferral, particularly with regard to timing.
In this article, the key dates and deadlines in a 1031 Exchange timeline are described. With this knowledge, readers will be more informed about the 1031 Exchange process and should be able to use this information to de-risk their next transaction.
At First National Realty Partners, we have a significant amount of experience in working with investors to place 1031 Exchange funds. To learn more about our current commercial real estate investment offerings, click here.
To understand the key dates in the timeline, it helps to first know some key information about how a 1031 Exchange works.
How Does a 1031 Exchange Work?
As described above, a 1031 Exchange involves the sale of an investment property, known as the “relinquished property”, and the use of sale funds to purchase a new property, known as the “replacement property.” Most 1031 Exchanges are known as “delayed” transactions where the relinquished property is sold first and some period of time passes before the replacement property is purchased. But, there is another type known as a “reverse exchange” where the same process happens in reverse. The replacement property is purchased first and the relinquished property is sold second.
In both cases, there are key dates and deadlines that investors must be aware of to ensure they abide by the 1031 Exchange rules established by the IRS.
General Dates & Deadlines for a 1031 Exchange Timeline
There are three key dates in 1031 Exchange timing: the day the relinquished property is sold, the day the replacement property is identified, and the day that the purchase of the replacement property is completed. More detail is provided on each below.
Day 0: The Relinquished Property is Sold
On the day that the sale of the relinquished property closes, a clock starts ticking. For the sake of this article, it is referred to as Day 0.
Day 45: Declare The Replacement Property
From Day 0, the exchanger has a 45-day identification period to formally declare the replacement property that they intend to purchase. Specifically, the rules state that exchangers are required to “..provide an unambiguous description of the potential replacement property prior to midnight on the 45th day after the close of the relinquished property. In most cases, a legal description of the property and/or a submitted purchase agreement will suffice. However, if the exchanger intends to purchase more than one replacement property, they must adhere to the following identification rules:
- Identify up to three properties of any value, as long as they have the intent of purchasing at least one.
- Identify more than three properties, as long as the aggregate value does not exceed 200% of the market value of the relinquished property
- Identify more than three properties with an aggregate value in excess of 200% of the value of the relinquished property as long as 95% of the fair market value of all properties identified is acquired.
NOTE: Any properties that are purchased and closed within the 45 day period are considered to be identified for the purposes of the 1031 Exchange.
Day 180: Close on the Purchase
Real estate investors have 180 calendar days from the sale of the replacement property to close on the sale of the replacement property. It is important to note, this is not 180 days from the identification of the replacement property, it is 180 days from the sale of the relinquished property. This is an important distinction that could have a material impact on the tax liability in the transaction.
To help put these dates in context, the following diagram illustrates the exchange timeline described above:
As we mentioned above, this timeline is particularly important for two types of 1031 Exchanges, the delayed exchange and the reverse exchange.
Timeline and Steps for a Delayed 1031 Exchange
The timeline and steps for a delayed 1031 Exchange are as described above. The clock starts ticking on the day the relinquished property is sold and the exchanger has 45 days to identify the replacement property and 180 days to complete the purchase of it.
Timeline and Steps for a Reverse 1031 Exchange
As the name suggests, the steps are opposite in a reverse exchange. The exchanger purchases the replacement property first. Then, they have 45 days to identify the relinquished property and 180 days to complete the sale of it. This may seem counterintuitive, but it is common for real estate investors to have multiple properties in their portfolio. When this is the case, they need to identify which one they are going to sell.
What Happens If The Rules Are Not Followed?
The point of a 1031 Exchange is to defer taxes. For many real estate investors, this is a powerful way to grow their investment portfolio over time. But, if the timeline rules are not followed, the consequence is that the sale could become taxable.
For example, suppose that a real estate investor books a $1MM gain on the sale of their investment property and they are subject to long term capital gains taxes at a rate of 20%. This means that they could be subject to a potential tax liability of $200,000 if the required timelines are not met.
For this reason, it is always a good idea for real estate investors to work with a qualified intermediary or to seek legal advice from a qualified real estate attorney or CPA to make sure they stay within 1031 Exchange rules, as outlined in the internal revenue code. While both parties may charge a fee for their services, it is far less expensive than the potential tax bill should a rule be broken.
Summary & Conclusion
A 1031 Exchange is a real estate transaction that allows real estate investors to defer capital gains taxes on the profitable sale of an investment property as long as they use the sale proceeds to purchase a “like kind replacement property.”
To receive full tax deferral, investors must adhere to a number of rules including two that have to do with the 1031 Exchange timeline. They have 45 days from the sale of the relinquished property to formally identify a replacement property and 180 days to complete the purchase. If the transaction is a “reverse” exchange, the same rules apply, just in reverse.
Failure to adhere to these rules could result in the imposition of capital gains taxes and/or income tax (depending on how long the property was held), which could be very expensive. For this reason, it is a best practice for taxpayers to seek the assistance of qualified professionals to ensure this does not happen.
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