There are two time periods that must be met in a 1031 exchange and both begin with the closing of your first relinquished property. The time periods run concurrently and are based on calendar days not business days.
The 45-Day Identification Period requires the identification of like-kind replacement property. The identification must be made in writing and signed by all Exchangers. A written identification signed by your agent, such as your attorney, accountant or real estate professional, instead of you will be an invalid identification.
Tip: There is no way to extend the 45-Day Identification Period but you can take advantage of the time you have before the 45-Day Identification Period starts. Begin looking for your desirable replacement property before you have your relinquished property sold. You can sign an Agreement of Sale for the replacement property before conveying title of the relinquished property to a buyer. You can request to be reimbursed from the exchange proceeds for any out-of-pocket earnest money deposits made on the replacement property. The reimbursement is made at the time of acquisition of the replacement property. The dates the Agreements of Sale are signed do not matter and the time deadlines are based on the actual conveyance dates.
The 180-Day Exchange Period* runs concurrently with the 45-Day Identification Period and requires the acquisition of all desired identified replacement properties. Signing an Agreement of Sale is not sufficient. The Taxpayer must actually take legal and equitable ownership of the replacement property on or before the 180th day.
* The 180-Day Exchange Period will be shortened to the due date of the federal income tax return of the next calendar year unless a timely and proper IRS extension is filed for their return.
The 3 Property Rule
The 200% Value Rule
Many Taxpayers find the 200% Rule very confusing. Please keep in mind that it only applies if identifying four or more properties. If identifying one, two or three properties, there is no limit to the combined dollar amount of all properties identified.
Exceptions to the 3-Property Rule and the 200% Value Rule:
Any Taxpayer or tax entity can complete an exchange. However, title to the replacement property should be taken the same way title of the relinquished property was held. The only exception to this rule would be the use of a disregarded entity, such as a single-member limited liability company (LLC). Except in a community property state, a married couple wishing to use a single-member LLC to acquire the replacement property would have to create a separate single-member LLC for each spouse and each LLC would acquire a 50% tenant-in-common interest in the replacement property. If using a single-member LLC, the taxpayer would have to elect to be treated as a disregarded entity for tax purposes. Some other disregarded entities, such as an Illinois Land Trust (Rev. Ruling 92-105) and a revocable living trust (Rev. Rul. 92-105, Rev. Rul. 70-376 and Rev. Rul. 88-103) will also qualify.
Maximizing your Tax Deferral
To maximize your tax deferral, you must acquire replacement property of equal or greater net value and equity. The value of the relinquished property is its net selling price which is the contract sales price less routine transaction expenses. The equity in the relinquished property is the net after all routine transaction expenses and mortgage payoff(s). A trade down in value or equity creates a taxable event known as “boot.” You are taxed on the greater trade down (value or equity). You should always discuss your situation with a tax and/or legal professional before proceeding with a 1031 exchange.
Deferral of State Gain
All states with an income regime either follow the federal tax code or have their own version of Section 1031 allowing like-kind exchanges.
Pennsylvania and Like-Kind Exchanges
Exchanges initiated after January 1, 2023, by transferring title of the relinquished property to a buyer will be eligible for 1031 tax-deferral treatment in Pennsylvania. Pennsylvania residents selling property in or out of the Commonwealth and non-residents selling property in Pennsylvania will not only be able to defer federal gain, but they will also be able to defer Pennsylvania income tax.
Note any exchanges where a relinquished property was transferred on or before December 31, 2022, will still be subject to the Pennsylvania state income tax. Any resident taxpayers as well as any non-resident taxpayer that sold in the Commonwealth will be required to pay Pennsylvania income tax. Non-resident taxpayers that sold property in Pennsylvania are required to pay Pennsylvania income tax on the profits even if the taxpayer can complete a 1031 exchange in their home state or if there is no income tax in their home state. A 1031 exchange would allow the deferral of all federal taxes.
Non-Resident Withholding Tax
Many states have enacted mandatory non-resident withholding taxes that must be withheld at the time of sale if the seller is not a resident of that state. Closing agents in these states must submit a check representing the required withholding tax to the Recorder of Deeds in order to have the Deed recorded. When completing a 1031 exchange, you may file for an exemption but most states require this be completed prior to closing.
The following States currently have non-resident withholding requirements: California, Colorado, Delaware, Georgia, Hawaii, Maine, Maryland, Mississippi, New Jersey, New York, North Carolina, Rhode Island, South Carolina, Vermont, Virginia and West Virginia. Keep in mind other States may enact laws requiring a non-resident withholding tax.
Pulling Cash Out without Triggering a Taxable Event
After the exchange is complete, many advisors feel comfortable refinancing the replacement property and allowing you to use the equity for whatever purpose you wish. This refinance does not trigger a taxable event. Advisors suggest it is wiser to pull the cash out after the exchange is complete than to pull the cash out on the relinquished property prior to or immediately preceding the sale. Your tax advisor can help you determine what is best in your situation.
Basis of Replacement Property
The basis of the replacement property is lowered by the deferred gain. Essentially, the old basis is carried to the new property and increased by any additional property value acquired.
Depreciation of the Replacement Property
The basis of the replacement property acquired in a 1031 exchange is generally the same as that of the relinquished property less any cash received plus any gain recognized. Notice 2000-4 clarified how MACRS replacement property in a 1031 exchange should be depreciated. The MACRS replacement property should be treated in the same manner as the MACRS relinquished property with respect to your basis in the replacement property provided it does not exceed the adjusted basis in your relinquished property. The replacement property is depreciated over the remaining recovery period, and using the same depreciation method and convention as that of the relinquished property. Any excess basis in the replacement property is treated as newly acquired MACRS property. There will generally be at least two different depreciation schedules in place on one asset. Notice 2000-4 applies to properties placed into service on or after January 3, 2000. T.D. 9115 (2/27/04) is a clarification of Notice 2000-4 and gives you the option to elect out of this depreciation treatment.
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