Follow the Rules in Your 1031 Exchange

Previously, I’ve discussed why advanced planning and meeting timelines are so important in completing a successful 1031 Exchange. Well, as you might have guessed, there are several other key areas to pay attention to and this post addresses the next one: following the rules.

If you have completed a 1031 Exchange before or are just in the process of considering one now, chances are you realize there are a lot of rules that need to be followed. Internal Revenue Code Section 1031 is quite explicit in defining the processes that must be followed for a proper exchange.

As I’ve mentioned before, a 1031 Exchange is one of the best tax-advantaged investments available today for investors looking to sell real estate assets used for business purposes. But the complexities of an exchange may cause some to steer away from this opportunity and that doesn’t have to be the case. Working with an experienced professional who understands and takes the lead position on complying with all the rules, can help make the exchange process go quite smoothly.

There are a few rules, however, that I believe every potential 1031 Exchange investor should understand. I refer to them as the “big three” and they are generally responsible for most of the mishaps investors experience if they’re not given proper guidance.   

Rule #1 – Like-kind Property

Mistakes on this one aren’t surprising because the IRS doesn’t specifically define what a like-kind property is. However, over the years, the term has generally come to encompass (and has been supported by the courts) to include:

• Unimproved property
• Improved property
• Vacant land 
• Net-lease property
• Commercial buildings
• Rental properties
• Resort property
• Industrial property
• Retail property
• Office buildings
• Self-storage facilities
• Senior-living centers
• Hotels or motels
• Restaurants
• Daycare facilities
• And other similar types

This is not a definitive list. If you are selling an investment property, you must purchase an investment property. If you are selling a retail property, you can purchase a residential rental property. It does not need to be retail for retail, or residential for residential. If you have any questions as to whether the potential replacement property is an investment property, you can check with your Qualified Intermediary.

My experience has been that investors who get tripped up are those trying to use the sales proceeds from a primary or secondary residence, or a property held primarily for resale . . . for their exchange. These won’t fly!

Rule #2 – Debt Replacement – Equal to or Greater

This is another area that is confusing for investors. Most investors generally believe they must replace the debt on their relinquished property with debt of equal or greater value on the replacement property. Technically, this isn’t accurate. The IRS requires the exchanger to replace the “value” of that relinquished debt on the new property. That means the exchanger could choose to simply pay cash on the new property in an amount equal to the debt on the relinquished property. Confused? Not surprising, and just one more reason to work with a seasoned professional on your exchange.

Rule #3 – All Net Proceeds Must be Reinvested

Perhaps some investors stumble on this because they hold certain proceeds back from the sale of their relinquished property, with the desire of using those funds for other purposes. They may simply not realize that in order to take full advantage of tax-deferral on the net proceeds of the sale, then ALL of those funds need to be reinvested in the replacement property. The IRS rule allows exchangers to reinvest less than the full proceeds, but they need to be aware that any non-reinvested funds will be subject to capital gain income tax and depreciation recapture and will result in mortgage boot or cash boot.

I hope you now have a better understanding of these three trouble spots, and why it is so important to work with a professional for your exchange.

If you have any questions, please feel free to contact me.