Requirements of a 1031 Exchange

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.

• At any time during this 45-Day Identification Period, a written identification may be revoked and a new one made.
• If a like-kind replacement property has not been properly identified by midnight of the 45th day, the exchange will fail and you will be unable to defer the capital gains. On the 46th day (or the next business day), all funds, including interest earnings, from the exchange account will be paid to you.

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

• You may identify up to three properties regardless of their fair market value. You are not obligated to purchase all identified properties but you must purchase property that was identified.
• For example, if selling a relinquished property for $100,000, three replacement properties can be identified with a combined fair market value of $10,000,000 or more.

The 200% Value Rule

• You may identify more than three properties but their combined fair market value cannot exceed double (200%) the fair market value of the relinquished property.
• For example, if a relinquished property was sold for $100,000 and four or more replacement properties are identified, their combined fair market value cannot exceed $200,000 (200% or double the sale price of the relinquished property).

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 replacement property acquired within the 45-Day Identification Period will be treated as properly identified. You do, however, have to count your property and its fair market value in your calculations.
• If the 3 Property Rule and 200% Value Rule are violated, the property will still be treated as properly identified, provided that 95% of the combined fair market value of the identified replacement property has been acquired.
• For example, assume a $100,000 property was sold and five properties with a combined fair market value of $800,000 are identified. This will be treated as properly identified provided all five properties are acquired. It is almost impossible to acquire 95% of the property without acquiring all 100% of the properties.

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.

Any type of real property can be exchanged provided both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. The term like-kind when pertaining to real property exchanges is very broad. 

• Properties may be located anywhere within the United States (50 states or District of Columbia). U.S. territories are not eligible although Letter Rulings 9038030 and 200040017 allowed Taxpayer to acquire rental property located in the U.S. Virgin Islands. Temporary regulations issued in 2005 (T.D. 9194) provide for the inclusion of properties in the U.S. Virgin Islands, Guam and the Northern Mariana Islands.
• More than one property may be sold or acquired.
• Examples of like-kind real property that can be exchanged under Section 1031 include vacant land, office buildings, duplexes, apartment buildings, single family homes used as rentals, warehouses, farms, Bed & Breakfasts, 30-year leasehold interests, utility easements, conservation easements, cell tower easements, oil and gas royalties, co-tenancy interests and mineral rights. Tenant-in-Common Interests (TIC) and Delaware Statutory Trusts (DST) are also considered real property for 1031 purposes.
• Examples of non-like-kind real property that cannot be exchanged under Section 1031 include primary residences, “flips,” stocks, bonds, notes, mortgages, cash, equipment, goodwill, inventory and interests in a partnership.