If you own an investment property and you are thinking of selling it to acquire a new property, you should consider a 1031 exchange. A 1031 exchange is a swap of a real investment property for another, allowing an investor to defer capital gains tax. The 1031 exchange is named after IRS Section 1031 of the Internal Revenue Code (IRC). 1031 exchange is among the most popular tax liability strategies that savvy real estate investors take advantage of when selling and buying property.
It is also known as a tax-deferred exchange, Starker Trust, or a like-kind exchange. It was first authorized in 1921 after Congress realized the need to encourage reinvestment in the business. Many taxpayers use tax-deferred exchanges to increase cash flow by deferring capital gains taxes. You can defer taxes on the gains realized after the sale of real estate, provided you reinvest the gains into a replacement property.
In this article, I have put together some key points on 1031 exchanges, including the concepts, definitions, rules, and tips about 1031 exchanges.
Table Of Contents
- 1 What Is A 1031 Exchange?
- 2 How 1031 exchanges work
- 3 Understanding How a 1031 Exchange Works
- 4 The Roles of a Qualified Intermediary
- 5 The Rules and Requirements of A 1031 Exchange
- 6 Rules on the Identification of Replacement Property
- 7 Types of 1031 Exchanges
- 8 Depreciation and Why It Matters in a 1031 Exchange
- 9 Avoid Getting Boot While Replacing Your Property
- 10 Drop and Swap Exchanges
- 11 Tenancy-in-Common Exchanges
- 12 1031 Exchange and Estate Planning
- 13 The Bottom Line
What Is A 1031 Exchange?
The term comes from the section 1031 IRS code, and it allows real estate investors to swap investment properties for deferment of capital gains taxes. An investor sells one property and uses the proceeds to purchase another within a specific timeline. Investors must meet all the conditions, such as doing like-kind exchanges only and meeting the timeframes stipulated. Failure to do so can lead to tax implications. Only real property that is not a personal residence is allowed, which means the intangible property does not qualify.
How 1031 exchanges work
A 1031 exchange is a popular investment tool that allows real estate investors to swap out an investment property for a replacement property to defer the capital gains tax the investor would have paid at the time of sale. This is an ideal strategy if you seek to upgrade a property without paying taxes for the proceeds. Section 1031 of the Internal Revenue Code applies to other properties beyond real estate. However, like-kind exchanges mainly deal with land and buildings.
Under section 1031, any proceeds you receive after selling a property are taxable. In a like-kind exchange, the proceeds from the property sale must be transferred to a qualified intermediary instead of being transferred to the seller. The intermediary then transfers the sale proceeds to the seller of the replacement property. A qualified intermediary is a company or a person who facilitates the exchange by holding the funds obtained from the sale of the property until they are transferred to the person selling the replacement property. The intermediary does not have any other formal relationship with the parties exchanging the property.
Below are some of the reasons why you may consider a 1031 exchange:
- To diversify your assets or to seek a property with better return prospects
- If you own an investment real estate property, you could seek a managed property instead of managing the property yourself
- You might seek to consolidate several properties into one property for proper real estate assets planning
- To avoid the tax implications of depreciation recapture
- Turn your vacation home into a rental property and do a like-kind exchange. For example, you can stop using your beach house; rent it out for several months before exchanging it for another property.
- You can dispose of a single investment property and use the proceeds to buy several investment properties. You can use the proceeds to acquire up to 3 properties. If you acquire more than three properties, your qualified intermediary will take you through some extra rules.
Understanding How a 1031 Exchange Works
As a property seller, you can defer capital gains tax when you sell a property and put the proceeds towards another property of similar nature or value, usually known as like-kind property. There will be no income to tax, provided that you don’t receive any proceeds from the sale. In other words, you do not realize any profit from the sale because you transfer all the proceeds from the relinquished property to the replacement property seller. This is the primary idea behind 1031 exchanges, and here’s how a 1031 exchange works:
1. Identify the Property You Want to Sell and the One You Intend to Buy
In a 1031 exchange, the property you are selling and the property you want to buy must be like-kind. This means that the properties should be of a similar nature. It does not mean that the properties must be of the same grade or quality.
2. Choose a Qualified Intermediary
Also known as an exchange facilitator, a qualified intermediary plays an integral role in a like-kind exchange. The qualified intermediary holds funds in escrow until the transaction is complete. The funds from the relinquished property will go to the intermediary, who will then transfer them to the seller or the replacement property. You should be careful when choosing a qualified intermediary to ensure that you don’t lose money. A reliable qualified intermediary will also ensure that you adhere to all important deadlines and that you do not end up paying capital gains tax now instead of later.
3. Inform the IRS about Your Transaction
You should fill out IRS Form 8824 with your tax return to inform the Internal Revenue Service about your transaction. On this form, you will describe the properties (both the relinquished property and the replacement property), provide a timeline, and outline the parties involved in the exchange process and the amount of money involved. The relinquished property you dispose of and the replacement property acquired must meet the set requirements.
The Roles of a Qualified Intermediary
A qualified intermediary is a person or an entity that sells the relinquished property on your behalf, acquires the replacement property, and transfers the deed to you. The intermediary holds the proceeds from the exchange transaction so that the sale is not taxable, handling the transition of money from the investor exchanging properties and the seller of the replacement property. A qualified intermediary also prepares the legal documents and ensures that all transactions are completed within the outlined IRS guidelines. Below is a breakdown of a qualified intermediary’s roles and responsibilities:
- The intermediary coordinates with you ( the seller of relinquished property) on the 1031 exchange structure
- Prepares the necessary relinquished property and replacement property documentation
- Gives the appropriate documents and instructions to the title company or escrow about the exchange
- Handles proceeds from the sale of the relinquished property and deposits the money into a separate insured account
- Holds the money from the sale of relinquished property through the 45-day identification period
- Maintains information in writing regarding the potential replacement properties
- Once the replacement property has been selected, transfer the funds and disburse them to the escrow or title company to facilitate the purchase of the said property
- Gives the title to the seller
- Maintains complete records for the property seller
- Gives 1099 to the exchanger or seller and the IRS if necessary
When you choose a qualified intermediary, you should ensure that the intermediary:
- Observes transparency in transactions
- Has successfully completed compliance examinations
- Has vast real estate experience
- Offers fund security – your funds should be held in an FDIC-insured account for maximum security
Below, I have outlined the rules and regulations that govern a 1031 exchange, including the property and time requirements that real estate investors must understand.
The replacement property must meet the following requirements:
Like-kind and of Equal or Greater Value to the Relinquished Property – both the relinquished and replacement properties should be similar enough to be considered like-kind. Most real estate properties qualify as like-kind. For example, vacant land is considered to be like-kind to a real property improved with rental buildings. However, it is important to note that property within the U.S. is not like-kind to property outside the U.S.
Similar to Nature and Function – for example, you cannot exchange a vacation home to acquire a multifamily or rental property. Personal use properties like your vacation home, primary residence, or second home do not qualify as like-kind property. Under Section 1031, actual property and personal property (that can include vehicles, collectibles, equipment, machinery, artwork, boats, aircraft, and other intellectual property) can qualify as exchange properties. However, the actual property cannot be like-kind to personal property. Rules also apply to personal property. For example, trucks are not like-kind to cars.
You Cannot Hold The Proceeds of a 1031 Exchange at any Time – a qualified intermediary must hold all the funds involved in a like-kind exchange in an escrow. If you come into contact with the funds at any point, the funds become taxable.
A 1031 exchange does not apply to the following types of exchanges:
- Bonds, stocks, or notes
- Other securities or debt
- Trust certificates
- Partnership interests
Real estate investors must also adhere to certain timelines. Failing to adhere to the timelines could make the proceeds of a 1031 exchange taxable:
After selling the relinquished property, you will have 45 days to find a potential replacement property or property. You should designate the property you intend to acquire in writing and share the details with your qualified intermediary. The IRS allows you to designate up to three properties, provided you eventually close on one property. You can designate more than three assets, provided the assets fall under certain valuation tests.
You should close on the replacement property within 180 days of closing the sale of the relinquished property or after when your tax return becomes due, whichever is earlier.
One of the advantages of exchanging real estate is that almost all types of real property qualify as like-kind to other real estate property. Since the rules provide that you can only exchange real estate for real estate, the like-kind refers to the character or nature of the property, not its quality or class. Whether the real estate is improved or unimproved does not matter. Below are real property examples that you can exchange for any other type of real estate property:
- Business property
- Vacant plots
- Multifamily rentals
- Single-family rentals
- Improvements in property not already owned
- Vacation rentals, including Air BnB and VRBO
- Ranchland and farmland
- Water rights
- Gas, oil, and other mineral interests
- Conservation easements
- Delaware Statutory Trusts
- Billboard, cell tower, and fiber optic cable easements
The law doesn’t require that you identify replacement property in the same location as the relinquished property. There are only two geographic locations for the purposes of a 1031 exchange: inside the U.S. and outside the U.S. For example, you cannot use the proceeds of a company in Texas to acquire a property in Sydney, Australia. Property within the U.S. is only like-kind to another property within the U.S., while a property outside the U.S. is like-kind to another property outside the U.S.
Why should the replacement property be of equal or greater value? The real estate investor must invest all the equity in the relinquished property into the replacement property. Therefore, the purchase price of the property being acquired should be equal to or higher than the price of the property being disposed of. Sometimes, a real-estate investor may wish to receive some money from a like-kind exchange. Any money obtained from the relinquished property sale and not invested in the replacement property is known as boot. This amount is taxable.
Rules on the Identification of Replacement Property
There are three rules for the identification of replacement property:
3- Property Rule
According to the 3-property rule, you can identify up to three properties within the initial 45 days of the exchange, regardless of the total value of the properties. After you relinquish your initial property, you can identify and buy up to three replacement properties. The qualified intermediary will require you to state how many replacement properties you intend to acquire to avoid common pitfalls, including the early release of funds or the release of excess funds.
The 200% Rule
According to the 200% rule, you can still have a valid exchange even if you identify more than three replacement properties. The 200% rule states that a real estate investor can identify and close on numerous properties, provided that the combined value of the properties does not exceed twice the value of the relinquished property. You can determine the fair cash value of a property by using the listing price.
The 95% Rule
If you have violated both of the previous rules by identifying more than three properties and the combined value of the properties is more than double the value of the relinquished property, the 95% rule comes in. This rule states that the exchange can still be valid even if you violate the 3-property rule and the 200% rule, provided you purchase at least 95% of the property you identified through the exchange.
Types of 1031 Exchanges
The common types of 1031 exchanges are:
Deferred or Forward 1031 Exchange
In a deferred or forward 1031 exchange, the property seller and the qualified intermediary establish an exchange agreement before any sales transaction. The seller assigns the right to sell the relinquished property to the intermediary. The intermediary acts as the seller to sell the property and hold the funds in an exchange account for the seller’s benefit. The property seller will have 45 days to identify a replacement property from the exchange. After identifying the property, the rights to acquire the property are assigned to the intermediary.
The seller of the relinquished property must close on the replacement property within 180 days. After negotiating with the property seller and executing the contract, the seller of property assigns the purchase rights to the qualified intermediary. The intermediary sends the funds held in the exchange account directly to the closing agent, the seller receives their tax-deferred property, and finalizes the exchange.
Parking or Reverse 1031 Exchange
A reverse 1301 exchange, also called a parking exchange, occurs when an investor acquires the replacement property before selling the property being relinquished. The exchange company acts as a qualified intermediary when it services a forward exchange. When an exchange company services a reverse exchange, it takes the title of the replacement property through a single member LLC. It is known as an exchange accommodation titleholder, commonly abbreviated as EAT.
The relinquished property seller will first enter into a contract to purchase the replacement property and enter into a reverse exchange with the company acting as the EAT. Sometimes, an investor may not have all the necessary funds to buy the new property. The investor must select a bank to loan the required money to EAT.
The EAT acquires the title of the new property and holds or “parks” this title until the investor sells the property being relinquished through a typical forward exchange. After selling the property, the qualified intermediary transfers the money to EAT to purchase the replacement property. The EAT receives these funds and repays any financing sought by the seller of the relinquished property, who then takes ownership of the replacement property.
Improvement/ Construction/ Built-to-Suit 1031 Exchange
You may need to acquire the property you desire to complete renovations or construct improvements as part of the 1031 exchange replacement property. Any improvement on land that you have already acquired will not qualify as replacement property in a 1031 exchange. By utilizing an improvement or built-to-suit exchange, you can receive property that is improved to your specifications in a like-kind exchange.
When the exchange involves a new property that requires improvement, a built-to-suit exchange will allow the inclusion of property improvement costs in the value of the said property. A built-to-suit exchange can occur as either a forward or a reverse exchange.
A built-to-suit or construction exchange allows you to use deferred tax funds to finance the renovations or improvements of the new property. All the improvements should be completed within 180 days.
Depreciation and Why It Matters in a 1031 Exchange
Depreciation is an important aspect when you are considering a 1031 exchange. Every year, a percentage of an investment property’s cost is written off; this is depreciation. Upon the sale of a property, the capital gains taxes are computed based on the net-adjusted basis, reflecting the property’s original purchase price, plus all the capital improvements, less depreciation. You may have to recapture the depreciation if you sell a property for more than the depreciated value. This depreciation amount will be included in the taxable income from the sale of your property.
The depreciation recaptured increases with time. Therefore, many investors participate in a 1031 exchange to avoid the increase in their taxable income that the depreciation recapture might cause later on. When determining the value of a 101 exchange, you should account for depreciation recapture.
Avoid Getting Boot While Replacing Your Property
In a 1031 exchange, the new property should be of equal or higher value than the relinquished property. If the property is of a lower value than the property being disposed of, the difference is called a cash boot, and it’s taxable. If you use non-like-kind or personal property to complete the transaction, this is also boot but doesn’t qualify for a like-kind exchange.
An existing mortgage is allowable on either the relinquished or replacement property. The difference is treated like a cash boot if the new property you are buying has a lesser mortgage than the property you are relinquishing. You should consider these factors when considering the parameters of exchange.
Fees and expenses will also impact the value of the transaction and could be potential boot. Some of the expenses that you can pay with exchange funds include:
- Qualified intermediary fees
- Broker’s commission
- Related attorney’s feeds
- Filing fees
- Title insurance premiums
- Finder fees
- Related tax adviser fees
- Escrow fees
Fees and expenses that you cannot pay with exchange funds include:
- Property taxes
- Financing fees
- Insurance premiums
- Repair and maintenance fees
Drop and Swap Exchanges
In LLCs, some partners may be willing to make a 1031 exchange, while others are not. In this case, the LLCs can do a drop and swap. Partners in an LLC do not own property but have a property interest in the entity. Interest in the partnership cannot be used in a like-kind exchange. Special steps are needed when the members of an LLC partnership are not in agreement on the disposition of the property.
If you are a partner, you want to make a like-kind exchange, but the other partners are not willing, you can transfer your partnership to the LLC. You will, in turn, get a deed to an equal percentage of the property. This will make you a tenant in common with the LLC. When the property owned by the LLC is disposed of, your share of the proceeds will go to a qualified intermediary, and the other partners will receive their proceeds directly.
What happens if a majority of partners are willing to do a 1031 exchange? The disagreeing partner or partners will receive a percentage of the property at the time of exchange and pay taxes on their proceeds. The proceeds for the agreeing partners will go to a qualified intermediary. This procedure is known as a drop and swap. It is a common procedure in situations where partners in an LLC have different interests.
It is usually advisable to drop a partner or partner at least one year before you swap the property. Otherwise, the IRS may see the partners participating in the exchange as not qualified. If the drop is not possible, the 1031 exchange can first take place, and the partners not willing to continue can exit at reasonable intervals. This process is known as a swap and drop.
Below are the events of a swap and drop:
- The LLC makes a decision to sell, whereby the partners will split up
- The exiting partners leave the LLC
- The exiting partners receive a share of their proceeds
- The purchase of the replacement property is completed within 180 days
Tenancy-in-Common, like drop and swap, is another variation of 1031 transactions. Tenancy in common is not a partnership or a joint venture. It is a relationship that allows an investor to have fractional ownership of a large property. Up to 35 investors can pool their money and acquire a property. Upon selling the property, each investor can perform a 1031 exchange with their portion of the proceeds.
1031 Exchange and Estate Planning
A major benefit of the 1031 exchange is that the tax deferment will persist even after your death. If your dependents inherit assets received through a 1031 exchange, the value of the asset is stepped up to the fair market value. This automatically wipes out the tax deferment debt. Therefore, if you pass on while holding a property obtained through a 1031 exchange, your heirs will receive the asset at a stepped-up fair market value.
The Bottom Line
You can always roll your investments into new properties. However, as soon as you roll your investment into another asset, you have to incur capital gains taxes. The good news is that you can defer your capital gains taxes through a 1031 exchange, provided you invest the proceeds from the sale of an asset into a new property within 180 days. A 1031 exchange can help you to grow your wealth through real estate and avoid short-term capital gains.
However, like-kind exchanges are complicated transactions. Like-kind exchanges put some restrictions on the types of assets that can qualify for an exchange. Property qualifies as like-kind provided it is used for business or investment purposes. You should ensure that you have an experienced, qualified intermediary by your side. The intermediary will sell the asset on your behalf, purchase the replacement asset, handle the transition of the exchange proceeds, and help you to prepare all the legal documents to ensure that the transaction is completed according to internal revenue service guidelines.