1031 EXCHANGE TERMINOLOGIES
The Relinquished Property, the property that you sell, will be either personal property or real property, or both. The Replacement Property, the property that you buy, will be either real property or personal property, or both. The real properties must be “like-kind” and the personal properties must be “like-kind” to each other. It means that the properties are “like” in their use or characterization, such as both being used as the business or for investment properties
The second 1031 Exchange Rule says that that the Relinquished Property must be “property held for productive use in a business or for investment or in a trade”. The Replacement Property must be a property “which is to be held either for productive use in a business or for investment or in a trade.” A detailed analysis of which properties meet these criteria is available at Dealer Property and can be expanded on at Intent
The sales price of the Relinquished Property must be equal to or less than the price that you pay for the Replacement Property
The amount that you will be receiving at the closing on the sale of your Relinquished Property is Net Sales Proceeds. The 1031 Exchange Rules require that all of your Net Sales Proceeds can only be used in the purchase of your Replacement Property. The part you take out of the Net Sales Proceeds will be taxable to you as “boot.”
The name on the deed of the Replacement Property must be the same name that was on the deed for the Relinquished Property. It can be either you as an individual or an LLC, a C or sub-S corporation, a Partnership, etc. In case, if you sell the Relinquished Property as an individual, and buy the Replacement Property in the name of an LLC in which you are the sole member, and you have elected to be treated by the IRS for tax purposes as a Disregarded Entity, the seller and buyer will be considered to be the same under the 1031 Exchange Rules.
“45-Day Period” is the first of the two timelines for 1031 Exchange.
“Exchange Date” is the date on which you close on the sale of your Relinquished Property. Within 45 days of this “Exchange Date”, you must identify the Replacement Property that you intend to purchase. You have three ways to do this.
First, you can identify up to three properties without regard to the value of each, or the total value of all three. Or, you can identify multiple properties as long as the total value of all of the properties is not more than 200% of the value of the Relinquished Property. And finally, the most complicated of the 1031 Exchange Rules, you can identify multiple properties, without regard to the “200%” limitation, as long as you can close on enough of the properties to represent 95% of the total value of all of them.
This is the second timeline of 1031 Exchanges. Within 180 days after the Exchange Date, you must complete the purchase of your Replacement Property. If you do not complete the deal within this time, the funds will be disbursed to you by the entity holding your Net Sales Proceeds, and you will not be permitted to engage in a Section 1031 Exchange. You will have to pay Capital Gains and Depreciation Recapture Tax on the sale. However, the IRS will not impose penalties or interest.
The 1031 Exchange Rules say that you cannot buy your Replacement Property from or sell your Relinquished Property to, a person related to you, a related party, without having certain conditions imposed. A “Related Party” is your spouse, your sister, your brother, your child, your grandchild, your parent, or your grandparent. It also includes a corporation, partnership, Limited Liability Company, or similar business entity in which you own more than 50% of the interest. This percentage includes your spouse’s ownership as well. Related Parties can do a direct swap of properties, but each party must hold the acquired property for a period that is not less two years after the date of the last transfer. Each Related Party must continue to file Form 8824 for two years following the year of the 1031 Exchange. You can sell your Relinquished Property to a Related Party, but the Related Party is required to hold the property for the two year period described above. If the Related Party fails to do so, the transaction will be declared invalid under the 1031 Exchange Rules, and taxes, penalties, and interest will be imposed on both parties.
You will be held to the same two-year filing requirement for Form 8824, except that it could turn into three years for you because the period will start to run from the date that you acquire your Replacement Property, and this could be 180 days after the first closing and could cover three tax-filing periods. You are not prohibited from buying Replacement Property from a Related Party, with the same two-year reporting requirement for Form 8824, but it almost guarantees that the IRS will audit the transaction because this is where they find most of the abuse of the Section 1031 Exchange, family members trying to game the system.
The most important rule of the 1031 Exchange is that you will never have actual receipt of, constructive receipt of, or control over the Net Sales Proceeds. You must sign an Assignment of Benefits of your sales contract on your Relinquished Property to an independent third party. Usually, this is a Qualified Intermediary. A Qualified Intermediary (QI) is an entity that is not disqualified from providing the service by reason of having had a business or family relationship with you during the past two years. So the only reason that they are called qualified (intermediary) is that they are not disqualified by the definition. It has nothing to do with their ability to do the job. The Qualified Intermediary (QI) is not licensed, or even registered, by the IRS, or any other federal, state, or local government regulatory agency.