1. Like-Kind Property: The replacement property must be of "like-kind," a term that is broadly interpreted.  Like kind does NOT mean apartment for apartment.  For example, you can exchange a single family rental for self storage or an office building for mineral rights (check out our webinar).
   1.  Essentially, it means that both the original and replacement properties must be used for business or investment purposes.
      
      
2. Timing:  This is where the rigidity comes in.  There are strict timing rules. The investor has 45 days from the date of sale of the original property to identify potential replacement properties. Furthermore, the purchase of the replacement property must be completed within 180 days from the sale of the original property.
     
3. Qualified Intermediary (QI): The proceeds from the sale of the property must be transferred to a Qualified Intermediary, rather than the seller of the property, to avoid constructive receipt and disqualification of the exchange.
   1. Flow of Funds - never never never touch ANY of the cash!  If you touch the cash from the sale for a day, you have completely ruined the ability to complete a 1031 exchange.
      
      
4. Same Taxpayer: The tax return and name appearing on the title of the property sold must be the same as the tax return and name that will appear on the title of the replacement property.  For example, if you own a property through a Partnership, the full partnership must complete the 1031 exchange.  This often causes problems as not all partners want to complete the 1031.
   1. In this case, you may be able to get creative with legal structuring (ask us about the TIC Structure)

• Basis: The basis in the replacement property is the same as the basis of the property given up, with adjustments made for any additional money paid or received. 
  • If you sell a property for $300,000 that had an original adjusted tax basis of $200,000, and then use those funds to purchase a new property for $300,000, the basis of your new property is also $200,000.
    
    
• Debt: Debt (your mortgage) on the replacement property must be equal to or greater than the debt on the property sold. 
  • If not, the buyer will be taxed as if this were "boot" (a non-like-kind property received in an exchange), and it will be taxable to the extent of gain realized on the exchange.
    
    
• Depreciation: The depreciation recapture on the property sold is deferred, as is the capital gain, but the replacement property essentially takes over the depreciation schedule of the sold property. 
  • This means that the previous depreciation will affect the basis of the new property, and the new property's depreciation schedule will continue from where the old one left off.

An investor owns a small apartment building that was purchased for $500,000 several years ago. Over the years, the property has been depreciated, and its adjusted tax basis has reduced to $300,000. 

The property is now worth $800,000 on the open market, and the investor decides to sell it. 

Instead of paying capital gains tax on the sale, the investor comes to Anomaly for a solution and we decide that it is best to reinvest the proceeds into a larger apartment complex.

The small apartment building is sold for $800,000, and the investor identifies a new property worth $1,000,000 on day 44 and closes on day 176.

To complete a successful 1031 exchange, the investor uses all the proceeds from the sale ($800,000) and adds additional funds to meet the $1,000,000 price of the new property. 

Since the new property's debt level is equal to or greater than that of the old property, and the exchange is completed within the required timelines, the investor successfully defers any capital gains taxes that would have been due on the sale of the original property.

In this example, the basis of the new property for the investor is adjusted to account for the exchange. 

The original basis of $300,000 from the sold property is carried over to the new property, with adjustments made for the additional $200,000 invested to purchase the new property. 

This results in a new basis of $500,000 for the larger apartment complex. 

The depreciation schedule for the new property will continue based on the original property's depreciation, adjusted for the new basis.

Planning Tip - we CAN cost seg the new $200,000!  This is often overlooked but can add additional tax savings.

1031 exchanges can appear straightforward at first glance but there are many traps for the unwary.  At Anomaly, we work with a few Qualified Intermediaries to ensure the transaction is smooth and completed in a timely manner.

Remember, 1031 exchanges are NOT the only option for exiting real property.  Check out our OZ Strategies and Lazy 1031 Strategies as well!