1031 Exchange

Important 1031 Exchange Rules

A tax payer needs to be aware of the various 1031 Exchange Rules framed by the IRS to enable him/her to claim deferment of capital gains tax on the sale of a property.

Some important 1031 Exchange Rules are as given below.

A 1031 tax deferred exchange is one in which a person sells his/her owned qualified property. Such property is known as the relinquished property. The tax payer in lieu of it then purchases qualified property, which is known as the replacement property. Both the relinquished and replacement properties must fit certain stipulated criteria.

These are given below.

Both the properties must be in the nature of real estate used for productive purposes in business or trade or solely held for investment purposes. However, second homes which may normally be used for investment purposes, but are also used as vacation stay homes are disqualified. A person can sell an investment property to buy a property used for business purpose or vice versa.

Properties owned for personal use or those available with dealers for sale purposes are disqualified.

The purchase of a replacement property from a related person can disqualify a tax payer from claiming 1031 tax deferment benefits. In case, the tax payer sells the relinquished property to a related person, the related person cannot sell it before 24 months have elapsed after acquiring it. In case, the related person resells the property acquired from the taxpayer for 'cash', issues of potential abuse of the 1031 provisos are triggered.

The relinquished property sale and the replacement property purchase need to be mandatorily implemented by the tax payer through an Exchange Agreement.

It is drawn up by a third party known as the Qualified Intermediary. The tax payer (known as the Exchanger) needs to sign the Agreement together with the Intermediary. By signing the Agreement, the Exchanger transfers the right of sale of the relinquished property and the right of purchase of the replacement property on his behalf to the Intermediary. The Intermediary effects the two transactions, and holds the net cash proceeds.

The Qualified Intermediary cannot be an Exchanger in any transaction or a seller or a buyer. Further, he/she cannot be a Realtor or Broker.

The Exchanger gets only 45 days from the date of sale of the relinquished property to identify potential replacement properties. A written notification needs to be received by the Intermediary within this deadline. In the notification, identification details of potential properties must be provided, which cannot be revoked after the deadline.

The purchase of the replacement property must be completed within a certain date. The date is the earlier of 180 days of the sale of the relinquished property or the due date of the taxpayer's income tax return of the fiscal in which the relinquished property transaction takes place.

In case the tax payer violates any of the 1031 Exchange Rules, capital gains tax will be leviable on the tax payer as per IRS income tax laws.