For landowners looking to sell their land and diversify their investment portfolios, there is no greater tool than the 1031 exchange. Named after section 1031 of the Internal Revenue Code, 1031 exchanges allow landowners to defer capital gains taxes on the sale of their property by reinvesting the profits into another property.

What follows is essential information for any landowner looking to maximize the value of their land investment!

How Do 1031 Exchanges Work?

A 1031 exchange allows a landowner to defer the capital gains taxes on the sale of their property by reinvesting those profits into a property of like kind. Only some properties qualify for a 1031 exchange, however, as MN Land Professional Terri Jensen explained during her appearance on the National Land Podcast, both the relinquished property and the replacement property must be income-producing.

Jensen stated, “It’s income-producing to income-producing. So those kinds of properties would include anything from residential properties that are rented out, multifamily, duplexes, apartments, and commercial properties like retail, or industrial. Also agricultural land, oil and gas interests, mineral, water, or air rights, easements in perpetuity, and vacation rental properties.”

One of the most important aspects of performing a 1031 exchange is the timeframe, as failing to stick to the stringent deadlines could leave the landowner on the hook for their capital gains taxes. Jensen explained the timeline of a 1031 exchange, stating the following:

“The timeline for a 1031 exchange starts the day that you close on your relinquished property. From the day that you close on that property, you have 45 days to identify a property or properties that you want to exchange into. You have a total of 180 days to complete the 1031 exchange, and that includes the 45-day identification period. If you miss any of those deadlines, then you cannot do a 1031 exchange and are now responsible for those capital gains taxes.”

How Are Replacement Properties Identified?

As noted above, the replacement property must be identified within 45 calendar days of the closing date on the sale of the relinquished property. When it comes to identifying a replacement property, landowners can typically follow one of three rules.

The Three Property Rule

The Three-Property Rule allows the seller to select up to three potential replacement properties during the 45-day identification period. Ultimately the seller must close on one or more of these properties within the total 180-day exchange period to qualify for tax deferment. This option is good for landowners who are seeking a simplified approach to finding a replacement property as it provides flexibility without overwhelming them with too many choices.

The 200% Rule

The 200% Rule states that a seller may identify any number of replacement properties so long as the combined fair market value of these properties does not exceed 200% of the value of the relinquished property. Like the Three-Property Rule, the seller is required to close on one of these properties within the 180-day exchange period. 

This identification method provides similar flexibility to the Three-Property Rule but requires careful consideration of the value of the identified properties to ensure compliance.

The 95% Rule

You could also use the 95% rule which states if you’ve gone over 200% of the sale price, then you have to purchase at least 95% in value of what you’ve identified.

3 Ways to Avoid All Taxable Gain Through a 1031 Exchange

The most beneficial aspect of a 1031 exchange for landowners is the ability to defer capital gains taxes incurred on the sale of their relinquished property. Effective use of this tax strategy can help landowners maximize the value of their real estate investment and put them in an advantageous position to either sell again later or leave their holdings to inheritors. 

Jensen explained that there are a few requirements landowners need to meet for all of their capital gains taxes to be deferred through a 1031 exchange. Jensen stated, “If you want to avoid all taxable gain when you do an exchange, there are three ways you can do that. The replacement property’s fair market value has to be equal to or greater than the fair market value of the property that you’re selling, the relinquished property.

The second would be that all of the exchange proceeds from the sale of the relinquished property must be used to acquire the replacement property. Thirdly, the replacement property debt must be equal to or greater than the relinquished property debt to avoid capital gain due to debt relief.”

Who Should You Consult to Perform a 1031 Exchange?

There are quite a few factors to consider when performing a 1031 exchange, which is why it’s recommended to seek the assistance of a few different professionals throughout the process. In addition to the help of a Land Professional, there are a few other experts landowners should consult before performing a 1031 exchange, as Jensen explained. 

She stated, “Especially if you’ve owned the property for a long time, market conditions change and your accountant is definitely one of the first people you should be talking with to find out what your capital gains are going to be.” A better understanding of what capital gains taxes may be incurred on the sale of a property will be significantly helpful for any landowner in deciding what’s right for their property and financial situation.

The other person that landowners will need to work with is a qualified intermediary. Qualified intermediaries are essential to any 1031 exchange, as Jensen explained, stating, “On the day that you close the sale, if you touch those proceeds as the seller, you cannot do the 1031 exchange because a qualified intermediary has to handle those proceeds. 

So you’ll want to be sure that whoever your QI is, is qualified to do that and covered by a fidelity bond so you know that they’re a trusted entity who can handle this. They could be from a company like Land 1031 which NLR is involved with and has qualified people who can handle a 1031 exchange. You want to be sure that you’re working with reputable people.” 

A 1031 exchange is a fantastic way for landowners to defer some or all of the capital gains taxes on the sale of their property while still acquiring a new piece of land. If you’ve got questions about the 1031 exchange process, reach out to Land 1031 or contact your local Land Professional today!