In commercial real estate, the 1031 exchange is a tool used by savvy investors to defer or avoid paying capital gains tax on the proceeds of a sale by using the money to purchase another property of equal or similar value within a period of 180 days.
The phrase “1031 exchange” was derived from Section 1031 of the US Internal Revenue Code. According to this section, “No gain or loss shall be recognized if property held for use in a trade or business or for investment is exchanged solely for property of like kind.”
Therefore, when a seller relinquishes or sells their commercial property, they can use the 1031 exchange to have a third party or “accommodator” hold on to the proceeds, until a replacement property is purchased using the funds in escrow.
There is no set limit on the number of times and the frequency an investor can utilize the 1031 exchange.
Here are seven 1031-exchange rules in California every real estate investor should know:
Rule # 1: The 1031 exchange should only be used for investment or business properties
A qualified 1031 exchange transaction means your relinquished property and replacement property will be used to generate passive income. You cannot use the 1031 exchange for residential homes. The exchange does not cover properties bought for the purpose of flipping, as well.
Rule #2: The property you purchase must be a “like-kind” property
To qualify for the 1031 exchange, the relinquished property and the replacement property should be “like-kind,” which is defined by the nature of the property and not its physical characteristics or grade.
For instance, a parcel of commercial land can be exchanged for an apartment complex. An industrial building can be exchanged for a retail shop, and vice versa. In addition, the 1031 exchange applies only to real estate and cannot be used in exchange for other assets like artwork or equipment.
Rule #3: The properties that are sold and bought should be held by the same taxpayer
You can’t apply the 1031 exchange if you buy a “like-kind” property through a limited liability company (LLC). As the titleholder of the property you just sold, you must buy the new replacement property under your name.
However, the single member limited liability company (SMLLC)is the exception to this rule. Because an SMLLC requires only one owner and that owner is you, you can use the 1031 exchange to buy your new property under an SMLLC.
Rule #4: Identify your replacement property and mind your timelines
Once you have sold your property, you must identify potential like-kind property within 45 calendar days.
You can identify potential property in three ways:
- The three-property rule – The exchanger can identify up to three potential replacement properties of any value.
- The 200% rule – The exchanger can choose more than three potential replacement properties. However, their combined values must not exceed 200% of the sold property’s sales price.
- The 95% rule – The exchanger can identify numerous properties regardless of the sold property’s sales price as long as they acquire a property that is close to 95% of the value identified.
You must purchase your new property or properties within 180 days after you have sold your relinquished property. Take note that the 45-day and 180-day time periods run simultaneously, which means you will have 135 days to purchase the replacement property after you identify it.
Rule #5: The net sales price of the replacement property must be equal to or greater than the relinquished property
In order to defer 100%of your capital gains tax, the property or properties you intend to purchase should have the same or exceed the value of your relinquished property. If you don’t meet this condition, you’ll have to pay tax on the difference.
The mortgage amount of the replacement property should also be equal to or exceed that of the relinquished property.
Rule #6:A qualified intermediary is in charge of holding the funds
The 1031 exchange requires a qualified intermediary or “Accommodator” to hold the funds involved in the exchange and then transfer them to the seller of the replacement property.
If you have control of the funds in any way during the transaction, the whole exchange could be considered void.
Rule #7: California clawback
The 1031 exchange rules in California has an extra provision called a “claw back.” It means that any property purchased in California is still subject to state taxes even if it was exchanged for another property.
For a more in-depth look at the 1031 exchange, check out our step-by-step guide. At R&Z Real Estate Advisors we offer 1031 exchange services so you can achieve your real estate goals with ease. Contact us here or call us at 650.391.1758 (Tony) and 650.391.1781 (Ray) to learn more.