Bare Bones Basics of a 1031 exchange

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1031 exchanges, at least as we know them today, have been around since 1991. Most people in the real estate industry have heard of them and seem to have a good working grasp of how they work, and what the requirements are. Occasionally we get calls from someone who has not heard of a 1031 exchange, or has no clue what the rules are. So now would be a good time to do a refresher course, if you will, on the basic rules of an exchange.

Rule #1 – Both the Old Property and the New Property must be held for investment or used in a trade or business. Many people think that if you sold a purple duplex, you must buy a purple duplex. This is not the case – you can buy any other kind of investment real estate: you could buy an apartment building, an office building, a warehouse or bare land.

Rule #2 – 45-day identification requirement. From the day you close the sale of your Old Property, you have 45 days to complete a list of properties you might want to buy. Typically this list will have three properties or less, because you can list up to three properties with no limitations. For example, if Fred and Sue Investor sold their Old Property for $100,000, they could list three properties for ten million each (a total of thirty million) because there are no limitations. If your list has more than three properties a different set of rules kick-in which will complicate your exchange. So keep it simple: limit your list to three or less.

The 45 days are calendar days. That means that if the 45th day falls on a Saturday or Sunday, or a holiday such as the 4th of July or New Years Day – that is THE FINAL DAY: you must have your list completed by midnight on that day. There are no exceptions or extensions!

Rule #3 – 180-day purchase requirement. This rule is pretty simple: again from the day of closing, you have 180 days to close the purchase of what you are going to buy. And what you buy has to be on your 45-day list. The 45- and 180-day requirements run concurrently, meaning that when your 45 days are up, you only have 135 days left to close. And like the 45-day identification requirement, there are no extensions.

Rule #4 – Qualified Intermediary requirement. You cannot touch the money between the sale of your Old Property and the purchase of your New Property. By law you have to use an independent third party to handle the exchange.

“...Many intermediaries say that you will have a separate account – but they don’t mean a separate bank account...!”

There is no licensing or regulation requirement of Qualified Intermediaries in Colorado. Needless to say, with so much money being held by unregulated and unlicensed people, there are going to be problems. There have been some spectacular frauds in the industry, including a couple here in Denver and one up in Breckenridge. The only way you can protect yourself is to make sure the intermediary puts your money in a separate bank account just for you, and that the account require two signatures to move the money. Many intermediaries say you will have a separate account – but they don’t mean a separate bank account—they mean a separate account on their books. It is your responsibility to know where your money is. Have them give you the name and account number of the financial institution that is holding your money. Get a written letter or email from them telling you that there is no money in that account other than yours. If they are unwilling to do this, call another intermediary, like us, who will put your money in a truly separate bank account.

Rule #5 – Title Requirement. Any entity, such as corporations, trusts, partnerships, LLCs, etc. may do an exchange.  They all have the same rule: the tax return that holds title to the Old Property must be the same tax return that takes title to the New Property.  For example, if Fred & Sue are married (i.e., a joint return) and they sell the Old Property, then both Fred and Sue must take title to the New Property.

Rule #6 – Reinvestment Targets. To defer all of your capital gains tax, you must buy a property of equal or higher value than the one you sold. And you must reinvest all of the cash proceeds from the sale. Notice that you do not have to have debt on the New Property equal to or greater than the debt that was paid off on the Old Property. Many people think you do, but they’re wrong; you simply have to buy equal or up and reinvest all your cash.

These six rules apply to almost all 1031 exchange situations. If you're a typical real estate investor, this is really all you need to know. But if your exchange has some atypical situations attached to it (ie: title-holder's marital status changes during the exchange, or the real estate comes with other things like industrial equipment, etc.), be certain to consult with an exchange expert who knows the ins-and-outs of 1031 exchanges, and ALL the facets therein.

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