1031 Exchange simplified by 1031 sponsors

1031 exchange got its existence from the section 1031 of the IRC (Internal Revenue Code), under which the investor is allowed to sell the relinquished property, and use the proceeds for further reinvestment to buy one or more replacement properties. 1031 exchange helps the investor to defer the capital gain taxes. If the investor wants to do a 1031 exchange then there is a deadline of 45 days to identify the property, and 180 days to acquire the replacement property.  

Under 1031 exchange the investor is allowed to buy only like-kind property. We can define the like-kind properties according to its nature or characteristics, not by the quality and look it has. So, there is a broad range of exchangeable properties. We can exchange a vacant land with commercial building, or the commercial building can be exchanged with the residential but cannot be exchanged with the artworks, i.e. under 1031 exchange the investment properties must be held for productive use. During the exchange of like-kind properties the taxpayer does not receive any profit from the sale of the relinquished property but only the exchange of the property.

For doing the 1031 exchange there are certain requirements which need to be fulfilled. First of all the investor must involve the qualified intermediary in the process to do the exchange. Qualified Intermediary plays an important role in the 1031 exchange because he is the person without whose involvement the exchange cannot be completed. The QI holds the proceeds of the relinquished property in an escrow account, and reinvest the proceeds to buy the replacement property. If the investor receives the cash of the relinquished property after the sale then he/she is disqualified from the 1031 exchange.

However, the investor has the opportunity to reinvest in one or more than one replacement property, but he needs to meet one of the following rules as discussed below:

To receive the full benefit of the rule, we should replace the property with equal or higher value.

1.      The Three-Property Rule: The three-property rule allows the investor to identify up to three replacement properties. The investor does not need to buy all the three properties only the value of the relinquished and replacement property must be equal.

2.      The 200% rule: Under the 200% rule of the 1031 exchange the investor is allowed to identify unlimited replacement of the property but its value must not exceed 200% of the total value of the relinquished property.

The 95% rule: The 95% rule is the rule in which you are allowed to identify as many properties as you want unless and until you acquire properties valued at  95% of their total value or more.