1031 Key Rules in Massachusetts

A 1031 exchange is a powerful tool for real estate investors in Massachusetts, but it comes with strict IRS guidelines. To successfully defer capital gains taxes, it’s essential to follow the rules carefully. Missing deadlines, mishandling funds, or choosing an ineligible property could result in losing the tax benefits. Below are the key rules every investor should understand before starting an exchange.

The property in Massachusetts being sold and the replacement property in Massachusetts must be “like-kind”—meaning they are both held for investment or business purposes. The IRS allows a broad definition of like-kind, meaning you can exchange:

• Single-family rentals in Massachusetts
• Multifamily properties in Massachusetts
• Commercial buildings in Massachusetts
• Industrial properties in Massachusetts
• Raw land in Massachusetts
• Retail spaces in Massachusetts

However, personal residences, fix-and-flip properties, and stocks or bonds do not qualify for a 1031 exchange in Massachusetts.

After selling the original property in Massachusetts, the investor has 45 days to identify potential replacement properties in Massachusetts. The identification must be in writing and submitted to a Qualified Intermediary (QI).

There are three ways to identify properties in Massachusetts:

1. Three-Property Rule – Identify up to three properties in Massachusetts, regardless of value, and choose one to purchase.
2. 200% Rule – Identify more than three properties in Massachusetts, as long as the total value does not exceed 200% of the sold property’s price.
3. 95% Rule – Identify any number of properties in Massachusetts, but you must close on 95% of their total value.

If no replacement properties are identified within 45 days in Massachusetts, the exchange fails, and capital gains taxes become due.

The investor in Massachusetts has 180 days from the sale date to close on the replacement property in Massachusetts. This deadline includes the 45-day identification period, so there is no extra time beyond this window.

If the transaction is not completed within 180 days in Massachusetts, the IRS will treat the sale as taxable, eliminating the tax deferral benefits.

Investors cannot receive or control the proceeds from the sale of their property in Massachusetts. Instead, the funds must be held by a Qualified Intermediary (QI) until they are used to purchase the replacement property in Massachusetts.

• If the investor takes possession of the funds in Massachusetts, the IRS considers it a taxable sale.
• A QI manages the exchange process, ensuring compliance and proper fund handling.
• Real estate agents, attorneys, CPAs, or family members cannot act as a QI in Massachusetts.

To fully defer capital gains taxes, the replacement property in Massachusetts must be of equal or greater value than the one being sold in Massachusetts. If the new property costs less, the difference (called "boot") may be subject to taxes.

For example:

• If a property sells for $500,000 and the investor buys a replacement for $400,000, the $100,000 difference is considered taxable gain.
• To avoid tax liability in Massachusetts, all sale proceeds must be reinvested, and any existing mortgage on the original property must be matched or exceeded on the new purchase.

The same person or entity that sells the original property in Massachusetts must also purchase the replacement property in Massachusetts. If an LLC, corporation, or trust owns the relinquished property, the same entity must acquire the replacement.

For individual investors, the replacement property must be titled in the same name as the original property owner to maintain tax deferral.

If there was a mortgage or loan on the relinquished property in Massachusetts, the investor must take on equal or greater debt when acquiring the replacement property in Massachusetts. A lower loan amount can create taxable income unless the investor offsets the difference with additional cash investment.

For example:

• Selling a property with a $300,000 mortgage means the new property must also have at least $300,000 in financing (or an equivalent cash contribution).
• If the new property is purchased with significantly less debt, the investor could be taxed on the shortfall.

Some investors need flexibility beyond a traditional 1031 exchange. Two alternative structures include:

1. Reverse 1031 Exchange in Massachusetts – The investor buys the replacement property first, then sells the original property within 180 days. This requires a specialized structure and more complex financing.
2. Build-to-Suit Exchange in Massachusetts – Proceeds from the sale can be used to construct or improve a replacement property. However, all improvements must be completed within 180 days for the full tax benefit.

These types of exchanges require additional planning and often involve more complex paperwork and funding arrangements.

Investors should be aware of common pitfalls that could result in losing 1031 exchange benefits:

• Missing the 45-day or 180-day deadlines in Massachusetts – The IRS does not grant extensions.
• Receiving the sale proceeds directly in Massachusetts – Always use a Qualified Intermediary.
• Choosing an ineligible replacement property in Massachusetts – It must be like-kind and held for investment purposes.
• Failing to reinvest all proceeds in Massachusetts – Any cash received (boot) may be subject to taxes.
• Changing ownership structure mid-exchange in Massachusetts – The same taxpayer must complete the transaction.

Avoiding these mistakes ensures the exchange remains valid and provides maximum tax deferral benefits.

The rules governing 1031 exchanges in Massachusetts are strict, but when followed correctly, they provide a powerful tax advantage for real estate investors in Massachusetts. Understanding the like-kind requirement, deadlines, debt rules, and proper handling of funds in Massachusetts is crucial to ensuring the exchange is successful and fully tax-deferred.

For investors looking to maximize real estate investments while deferring taxes, following these key rules is essential. Proper planning, working with the right Qualified Intermediary, and ensuring compliance with IRS regulations can make all the difference in preserving wealth and growing a real estate portfolio.