Three Primary Reinvestment Requirements
There are three primary requirements for a fully tax deferred exchange.
“Like kind” property
Reinvest all earnings from sale
Purchase property equal or greater in value
These primary requirements have further nuances addressed in other articles.
I. Sell and Purchase “Like Kind” Property
Only real estate property held for productive use in a (i) trade or business or (ii) for investment qualifies under the section 1031. Primary homes, vacations homes, and “flippers” that do not produce rental income do not fall under section 1031.
Like kind is otherwise broad and includes:
Residential, Commercial, Industrial or Retail rental properties
Condo
Raw, farm, or agricultural land
Ranch
30-year leasehold
An exchanger may sell out of and purchase into any of these. For example, an exchanger may sell a single family residential home and purchase a commercial property, or vice-versa.
II. Reinvest Net Earnings From Sale Into Replacement Property
For a fully tax-deferred exchange, the exchanger must reinvest all the net earnings from the relinquished property (sale) into the replacement property (purchase). Any earnings from a sale that are not reinvested into a replacement property are considered boot and subject to tax. This is considered a partial deferral. Partially deferred exchanges are viable and do not nullify the integrity of an exchange.
III. Purchase Replacement Property at Equal or Greater Value
Lastly, for a fully tax-deferred exchange, the exchanger must purchase replacement property equal or greater in value to the relinquished (sale) property. In determining this figure, however, the IRS permits an exchanger to subtract allowable costs such as real estate agent commissions, title and escrow fees, and exchange fees. The sale value minus these allowable costs will indicate the ‘target value’ for the exchanger to achieve.
If the exchanger does not replace the target value in the exchange, the short fall is considered the new taxable gain. For example, if an exchanger sells a $500k property and factors in allowable costs of $25k, the exchanger determines he must purchase replacement property at $475k in value (the target value). If, however, the exchanger can only successfully purchase property at $400k, this $75k difference becomes the new taxable gain.
