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1031 EXCHANGES
In 1991, the IRS established regulations under code section 1031 that allows owners of real property, either income, investment or business to sell the property on a tax deferred basis (defer capital gains tax) and replace the property with like-kind property. A sale and subsequent purchase of a second property is not sufficient to avoid income taxes on the capital gains from the sale of the first property; the transaction must be accomplished through an Exchange.
The definition of the like-kind exchange is very broad, it includes land, rental and business property; any of which may be exchanged for another. In other words an exchange can be accomplished between any properties held for income, investment or business use. In addition, two or more properties may be exchanged for one replacement property and/or vice-versa.
Exchanges can also be done between 100% ownership of the first property and an undivided percentage interest with multiple owners on the replacement property (and vice-versa). The only restriction however is that the replacement property must be held in the same name(s) as the original property that was sold. Replacement property identification guidelines:
- 3-property rule: You may identify any three properties as possible replacements for your relinquished property. Greater than 95% of all exchanges use the 3-property rule.
- 200% rule: You may identify any number of properties as possible replacements for your relinquished property as long as the aggregate value of those properties does not exceed 200% of the value of your relinquished property.
- You may identify any number of properties as possible replacements for your relinquished property as long as you end up purchasing at least 95% of the aggregate value of all properties identified.
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A property owner looking to do a 1031 Exchange must keep in mind that the replacement property must be located within a certain time frame:
- 45 Day Rule - The property owner either closes or identifies the replacement property. If the replacement property is not identified within 45 days of of closing on the relinquished (sold) property, limitations are imposed on the number of potential replacements.
- 180 Day Rule - The acquisition (closing) on the replacement properties must be completed within 180 days of closing on the relinquished (sold) property.
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