The Property Rules
What Are the Rules for Identifying Property in a 1031 Exchange?

Property Must Be Like-Kind. The replacement property must be like-kind to the relinquished property. Generally, real estate held for business or investment purposes is considered “like kind,” including commercial and residential property.

While residential property held for business or investment purposes qualifies for a like-kind exchange, one’s own residence or vacation home does not. (However there are other tax shelters available for the sale of a personal residence or vacation home.)

  • Equity and Debt Must Be Reinvested.

  • Second, the total value of the replacement property must be equal to or greater than the total value of the relinquished property to fully avoid capital gains taxes.

  • Any capital that is not reinvested is taxable “boot.”

Titles Must List the Same Owner. Lastly, the ownership title for the replacement property must be identical to the title for the relinquished property.

What Are the Stages of a 1031 Exchange?

  1. Before Starting: Plan Your Exchange
    Make plans to carry out a 1031 exchange, and engage a Qualified Intermediary (QI) in advance of the disposition of the property to be replaced.

  2. DAY #0: Complete the Disposition of the Original Property
    Sell the investment property to be replaced and have the proceeds held by the QI to avoid taking constructive receipt.

  3. DAY #45: Complete the Identification of Potential Replacement Property
    Work with a broker to identify potential replacement properties within 45 days after sale of relinquished property.

  4. DAY #180: Complete the Acquisition of the Replacement Property
    Close escrow on replacement property within 180 total days after disposition of the relinquished property.

An individual homeowner does not have to pay capital gains taxes on the proceeds from the sale of their personal residence if his capital gain is less than $250,000 (so long as certain conditions are met). A married couple filing jointly can shelter the proceeds from the sale of their home from capital gains taxes if their gain is less than $500,000. Note that these limitations concern the gain and not the total proceeds from the sale. Roughly speaking, if a home’s basis is $100,000 and it sells for $600,000, the capital gain is only $500,000. This tax shelter is called the “Home Sale Exclusion” and is detailed in Internal Revenue Code (IRC) section 121.

A 121 exclusion is quite different from a 1031 exchange

(The 1031 exchange allows an investor to defer the capital gains taxes that would otherwise be due on the sale of investment property).

In a 1031 exchange, the taxpayer cannot take constructive receipt of any of the sale proceeds.

Gross income is constructively received when it is made available without substantial limitations (26 C.F.R. 1.451-2). This means that you don’t have to physically hold cash in your hands to be taxed. For example, if a check for your funds is delivered to you, or if your funds are deposited into your account, you are in constructive receipt of those funds. An investor wanting to defer capital gains taxes under IRC section 1031 cannot take constructive receipt of the proceeds of the sale of the relinquished property. Rather, the proceeds must be held by a Qualified Intermediary.