A 1031 exchange provides real estate investors with the opportunity to defer capital gains taxes and depreciation recapture. However, to qualify, you must meet the strict deadlines specified in Section 1031 of the Internal Revenue Code. These deadlines also dictate the amount of time that funds from your property sale are allowed to sit in escrow.
Following, you’ll find details regarding two critical 1031 exchange deadlines and the repercussions for failing to meet them.
Opening an Exchange Account
The first step in initiating a 1031 exchange is to open an Exchange Account with a Qualified Intermediary (aka an Accommodator). This is typically done at the time when a sales contract has been completed to sell the investment property. The purpose of the Exchange Account is to receive the funds at the close of the sale escrow process which is then held in the account pending the decision of the investor to reinvest funds in identified replacement properties.
1031 Exchange Deadlines
The 45-day and 180-day rules create a non-negotiable timeline for 1031 exchanges. Since failing to follow these rules can cause your exchange to fail, it’s critical to understand exactly how they work.1
The 45-Day Rule
The 45-day rule states that you have 45 calendar days from the date you sell (close) your relinquished property to formally identify one or more potential replacement properties. The identification must be in writing, signed by you, and delivered to your Qualified Intermediary (QI). It must clearly describe each potential replacement property by providing a street address, distinguishable name, or a legal description. Additional information will be required if the replacement property is a Delaware Statutory Trust (DST) e.g., percentage ownership, proportions of equity and debt.
In addition, the identified properties must meet one of the following identification rules:
1) 3 Property Rule
The three property rule states that you may identify up to three replacement properties and then choose to purchase one, two, or all three of them.
2) 200% Rule
If you wish to identify more than three properties, you may choose to follow the 200% rule instead. While this allows you to identify a larger number of properties, you must ensure that the total fair market value (FMV) of the potential replacement properties is not more than 200% of the FMV of the relinquished property.
3) 95% Rule
Finally, the 95% rule allows you to identify more than three properties with a total FMV of more than 200% of the relinquished property’s FMV. However, you must acquire at least 95% of the value of the properties you identify. (This rule is rarely used.)
The 180-Day Rule
The 180-day rule states that you must complete the purchase of at least one of your identified properties within 180 calendar days from the date you sold the relinquished property. It’s important to note that the 45-day rule and the 180-day rule run concurrently, so if you take the full 45-days to identify your replacement properties, you’ll only have an additional 135 days to fully complete the transaction.
Full completion means that the title has been passed to the new owner. Since this would require payment for the property, it also means that funds may not remain in the exchange account after the 180th day.
It’s important to note that some qualified intermediaries will hold uninvested funds in the escrow account for the full 180-day period, even if the money is not going to be used to purchase a replacement property. To understand how your QI handles uninvested funds, be sure to review the holding terms in your Exchange Agreement prior to opening your exchange account.
Changing Amount of Allocated Funds after 45-Days
Many Qualified Intermediaries will limit changes that an investor can make to the allocations of funds among their identified replacement properties after the expiration of their 45-day identification period. For example, if 4 properties are identified and the investor subsequently decides to invest in only three of them, the Qualified Intermediary may not allow additional funds to be added to the three remaining properties.
There may also be limitations on reducing the investment amounts beyond specific limitations e.g., reductions greater than 25%. These limitations are more common when the replacement properties include DSTs. Therefore, investors should ask questions of their prospective Qualified Intermediary to fully understand the degree of flexibility that they may be allowed to make to change the relative proportions of their invested funds among their identified properties after 45-days.
What happens to any remaining funds in the Exchange Account after all replacement properties have been purchased? Typically, the investor would be required to send a notice to their Qualified Intermediary and any remaining funds would then be returned shortly thereafter. Some Qualified Intermediaries however will hold uninvested funds for the full 180-day period before returning them to the investor. Investors should review related provisions in their Exchange Account agreement to avoid unexpected surprises.
Penalties for Missing Deadlines
The 45-day and 180-day rules are strict deadlines. Since the IRS rarely grants exceptions, it’s critical to plan ahead and give yourself a buffer. You will not be allowed to identify additional replacement properties after the 45 days have passed, even if you run into issues like title defects or construction delays.
If you fail to meet the requirements of either rule, your transaction will not qualify for 1031 exchange treatment. In this case, you will owe capital gains tax on the appreciated value of your property sale, plus depreciation recapture and a net investment tax of 3.8%.
While you can’t control every variable, proper planning may help ensure you don’t miss these critical deadlines. For example, naming a Delaware Statutory Trust (DST) as one of your replacement properties can give you a backup option if you’re unable to close on the property you intend to purchase in time to meet the 180-day rule.
The team at First Guardian Group can guide you through the 1031 exchange process and help you create a plan to avoid missed deadlines. To learn more, contact us to schedule a consultation with a member of our team.
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1 Revenue Procedure 2018-58 permits extensions of the 45-day Identification Period and 180-day Exchange Period deadlines to certain taxpayers affected by Federally (formerly called “Presidentially”) declared disasters and terroristic and military actions.