Replacement Property

What is a Replacement Property?

A replacement property is a real estate asset acquired to complete a 1031 exchange, allowing an investor to defer capital gains taxes on the sale of a relinquished property. To qualify, the replacement property must be "like-kind" to the relinquished property, meaning it must be held for productive use in a trade or business or for investment.

How Replacement Properties Work in a 1031 Exchange

The core principle of a 1031 exchange is to swap one investment property for another, deferring the capital gains tax that would typically be due upon sale. This strategy requires strict adherence to IRS rules, particularly concerning the identification and acquisition of the replacement property. A Qualified Intermediary (QI) typically facilitates the transaction, holding the proceeds from the sale of the relinquished property until the replacement property is acquired.

Key Rules and Timelines

• 45-Day Identification Period: From the closing date of the relinquished property, the investor has 45 calendar days to identify potential replacement properties. This must be done in writing and delivered to the QI.
• 180-Day Exchange Period: The investor has 180 calendar days (or until the due date of their tax return for the year the relinquished property was sold, whichever is earlier) to close on one or more of the identified replacement properties.
• Identification Rules: Investors can identify up to three properties of any value (the 3-Property Rule), or any number of properties if their aggregate fair market value does not exceed 200% of the relinquished property's value (the 200% Rule).

Real-World Example

An investor sells a rental duplex in Phoenix for $600,000, realizing a $200,000 capital gain. To defer the estimated $40,000 in capital gains tax, they initiate a 1031 exchange. Within 45 days, they identify three potential replacement properties: a single-family rental in Scottsdale ($650,000), a small commercial office building in Tempe ($700,000), and another duplex in Mesa ($580,000). All are considered like-kind. Within the 180-day period, they successfully close on the Scottsdale single-family rental, acquiring a property of equal or greater value and debt, thus deferring the capital gains tax.

Important Considerations for Identifying Replacement Properties

• Like-Kind Requirement: While "like-kind" is broad (e.g., raw land for a commercial building), properties must be held for investment or business use. Personal residences do not qualify.
• Equal or Greater Value: To defer 100% of the capital gains, the replacement property's purchase price must be equal to or greater than the relinquished property's net sales price.
• Equal or Greater Debt: The investor must acquire debt on the replacement property that is equal to or greater than the debt relieved on the relinquished property. Any reduction in debt results in taxable "boot."