1031 Exchange Rules
 

1. Three-property rule: Up to three properties identified, no matter what their value.
2. 200 percent rule: Any number of properties identified, as long as their combined fair market value (FMV) does not exceed 200% of the FMV of all sold properties.
3. 95 percent rule: Any number of propertiesidentified, no matter what the aggregate FMV, provided 95% of the value of identified properties is acquired.

You must close on the identified replacement property(s) within 180 days from the sale date of the original property. There are four main rules governing 1031 exchanges:

1. The investor must reinvest all exchange proceeds. If an exchanger does not reinvest all exchange proceeds from the sale of the relinquished property, the balance received is considered "cash boot," and the investor will have to pay capital gains taxes on that amount.

2. The investor must acquire property with the same or greater debt. If an exchanger does not acquire a replacement property with an equal or greater amount of debt, he or she is relieved of a debt obligation, and this is called a "mortgage boot." The IRS considers this reduction in debt a benefit to the exchanger; therefore, it is taxable, unless it is offset by adding equivalent cash to the replacement property purchase.

3. The investor must use a "qualified intermediary" (also known as a "facilitator" or "accommodator") to hold the funds from the first sale until purchase of the new property is closed. The "qualified intermediary" (QI) is the person or entity who acts as the middle person in the exchange, providing the paperwork, oversight, escrow services, and expertise necessary to ensure that the transaction legally qualifies as an Exchange under Section 1031 of the Internal Revenue Code. Even though a 1031 Exchange is a complicated process, an Exchange using a good QI can become a simple transaction and look surprisingly like a standard sale.

4. The new investment must be in "like-kind" property - a term that is, fortunately, very flexible. It's true that IRS 1031 Exchange rules technically require the exchange of "like-kind" relinquished property for other "like-kind" replacement property. This doesn't mean, though, that exchanged properties must be of the exact same type (for example, that bare land is exchanged for bare land or an income property is exchanged for another income property). The actual definition of "like-kind" is far more empowering in its flexibility. In truth, any real property held for investment or real property used in a trade or business can be exchanged for any other real property held for investment or real property used in a trade or business.

Your qualified intermediary (an entity that is required to hold the proceeds of the sale of your sold property until reinvested) will ensure these rules are properly followed and your equity preserved. It is important to understand that you must have a qualified intermediary to complete a 1031 exchange.
 

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