WHAT IS A 1031 EXCHANGE?
THE BASICS FOR REAL ESTATE INVESTORS
If you own an investment property and are thinking about selling it and buying another property, you should know about the 1031 tax-deferred exchange. This is a procedure that allows the owner of an investment property to sell it and buy like-kind property while deferring capital gains tax. On this page, you’ll find a summary of the key points of the 1031 exchange rules, concepts, and definitions you should know if you’re thinking of getting started with a 1031 transaction.
WHAT IS A 1031 EXCHANGE?
In a field heavy with specialized terminology, it’s essential to start with the basics. A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code and allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale (within certain time limits) in a property or properties of like-kind and of equal or greater value.
The main requirements for a 1031 exchange are: (1) must purchase another “like-kind” investment property; (2) the replacement property must be of equal or greater value; (3) must invest all of the proceeds from the sale (cannot receive any “boot”); (4) must be the same title holder; (5) must identify new property within 45 days; and (6) must purchase new property within 180 days. These requirements are explained below.
What is Like-Kind Property? The property that you obtain must be a “like-kind property” in order for the transaction to be considered a 1031 exchange. However, this is a broad term, which means that the property you obtain doesn’t need to be exactly the same as the one that you relinquished. Almost any type of real estate can qualify for this exchange. For instance, you could exchange a duplex for an apartment building.
What Qualifies as Investment Property? The property must be a business or investment property, which means that it cannot be personal property. Your home will not qualify for a 1031 exchange. However, a single-family rental property that you own could be exchanged for commercial rental property.
How Do you Determine Equal or Greater Value in an Exchange? The equity and market value of the investment property that you purchase will need to be equal to or greater than what you sold your current property for. If your property has a $300,000 mortgage on a $1 million home, the property that you want to purchase must be worth at least $1 million and you must have the same ratio (or higher) debt on the property.
What is “Boot”? The term “boot” refers to non-like-kind property received in an exchange. Typically, boot is in the form of cash, mortgage debt, or personal property received in an exchange. If a replacement property is of lesser value than the property sold, the difference (cash boot) is taxable. If personal property or non-like kind property is used to complete the transaction, it is also boot, and taxable, but it does not disqualify the 1031 exchange. The presence of a mortgage is permissible on either side of the exchange. If the mortgage on the replacement is less than the mortgage on the property being sold, the difference is treated like cash boot. That fact needs to be considered when calculating the parameters of the exchange. If you want your exchange to be wholly tax-free, you cannot receive boot on the property. Any boot received will be taxed.
What Does the Same Title Holder Mean? The name that appears on the property title for the property that you sell will need to be the same as the name that you provide when purchasing a new property. An exception is allowed if you are the sole member of a limited-liability company wherein the property is passed from your company to you.
The 45-Day Identification Window. No matter which type of 1031 exchange you take part in, you will have 45 days from the close of the sale to find as many as three like-kind properties, with certain exceptions described herein. If you identify two or three properties, their total value must equal or surpass the value of the property that’s being sold.
The 180-Day Purchase Window. Once you sell your current property, you will have 180 days to purchase a replacement investment property and complete the 1031 exchange.
THE ROLE OF A QUALIFIED INTERMEDIARY
Under Section 1031, any proceeds received from the sale of a property are taxable. Because of this, proceeds from the sale must be transferred to a qualified intermediary, rather than to the seller of the property. The qualified intermediary transfers them to the seller of the replacement property or properties. A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other relationship with the parties exchanging property.
WHEN YOU MAY WANT A 1031 EXCHANGE? HOW CAN A 1031 EXCHANGE WORK FOR YOU?
The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property. Under a 1031, you may also reset the depreciation clock (explained in more detail below).
Aside from the tax benefits, you may want to complete a 1031 exchange if you find a property that has better returns, to diversify your assets, or to consolidate several properties into one. Alternatively, for purposes of estate planning, you may want to divide a single property into several assets for ease of distribution to the beneficiaries of the estate.
THE IMPORTANCE OF DEPRECIATION IN A 1031 EXCHANGE
RESETTING THE DEPRECIATION CLOCK
Depreciation is an essential concept for understanding the true benefits of a 1031 exchange. Depreciation is the percentage of the cost of an investment property that is written off each year, recognizing the effects of wear and tear. When a property is sold, capital gains taxes are calculated based on the property’s net-adjusted basis. The net-adjusted basis reflects the property’s original purchase price, plus capital improvements, minus depreciation.
If a property sells for more than its depreciated value, you may have to “recapture” the depreciation. That means the amount of depreciation will be included in your taxable income from the sale of the property.
The size of the depreciation recaptured increases with time, so you may be motivated to engage in a 1031 exchange to avoid the large increase in taxable income that depreciation recapture would cause later on. When dealing with investment properties, depreciation recapture is an important factor to account for when calculating the value of any 1031 exchange transaction.
CHOOSING A REPLACEMENT PROPERTY: TIMING AND RULES
Like-kind property is defined according to its nature or characteristics, not its quality or grade. This means there is a broad range of exchangeable real properties. Vacant land can be exchanged for a commercial building, for example, or industrial property can be exchanged for residential. You cannot, however, exchange real property for artwork, since that does not meet the definition of like-kind. The property must be held for investment though, and cannot be held for resale or personal use. This usually implies a minimum of two-years’ ownership.
In order to receive the full benefit of a 1031 exchange, your replacement property should be of equal or greater value. You must identity a replacement property for the assets sold within 45 days of closing on the sale and then conclude the exchange within 180 days. There are three rules that can be applied to define identification. You need to meet one of the following:
The three-property rule allows you to identify three properties as potential purchases regardless of their market value.
The 200% rule allows you to identify unlimited replacement properties as long as their cumulative value does not exceed 200% of the value of the property sold.
The 95% rule allows you to identify as many properties as you’d like as long as you acquire properties valued at 95% of their total or more. As a practical matter, this rule is difficult to adhere to. Basically, it provides that should the taxpayer have overidentified properties for purposes of the first two rules, the identification can still be considered valid if the taxpayer receives at least 95% in value of what was identified.
THE DIFFERENT KINDS OF LIKE-KIND EXCHANGES
There are a number of possibilities for making 1031 exchanges that vary in their timing and other details, each creating a set of requirements and procedures that have to be followed. The most common 1031 exchanges are explained below.
Simultaneous Exchange. Occasionally, the sale of the old property and the acquisition of the new property close in one extended closing. This is called a simultaneous 1031 exchange. Prior to the 1980’s, all exchanges were simultaneous.Forward/Delayed Exchange. This is easily the most common type of 1031 exchange that you can make. A delayed 1031 exchange is when the old or relinquished property is sold and closed before the replacement or new property is purchased and closed. For example, a taxpayer enters into a contract or agreement to sell real property held for use in business or investment. The property closes, paying off associated debt, and the remaining net proceeds are wired to escrow under the taxpayer’s tax identification number. Once the replacement property is in contract for an equal or greater amount, a second closing is scheduled, net proceeds are wired and the delayed 1031 exchange is completed.
Reverse Exchange. A reverse 1031 exchange represents a tax deferment strategy when, for a variety of reasons, the replacement property must be purchased before the relinquished or old property is sold. It is more complex than a forward 1031 exchange and requires careful planning. These types of exchanges require the establishment of an Exchange Accommodator Titleholder (EAT) as the exchanger cannot have possession of both properties at once. Apart from these few key differences, they follow the standard delayed 1031 exchange rules.
Improvement Exchange. An improvement 1031 exchange is used when a buyer wishes to exchange a piece of property for one of lesser value, but plans to make improvements and upgrades to the new property. To qualify as a 1031 exchange, the buyer must make enough improvements that the monetary value of the improvement work bridges the gap between the original values of the properties, and those improvements must happen within 180 days of the sale.
Construction Exchange. A construction exchange allows a property owner to sell an existing property, buy a piece of land, for example, and develop it. As with an improvement exchange, the investments made into the bare land within 180 days of the sale must be enough to equalize the value of the land and the property sold.
BENEFITS OF A 1031 LIKE-KIND EXCHANGE
Defer Capital Gains Tax. Without a doubt, the most important benefit of a 1031 exchange is the ability to defer capital gains tax. Rather than paying capital gains taxes, the cash can be used as equity in the new property, increasing buying power. This is used as a wealth building technique and allows you to keep the value of the taxes until selling the property later on.
Generate Cash Flow. A 1031 exchange can facilitate the transfer of non-income producing land for commercial or residential property that does produce income, creating a new stream of income for the property owner.
Diversify Your Portfolio. If you own a highly appreciated piece of property, a 1031 exchange can allow you to trade that property for two or more new properties, helping to diversify your real estate portfolio.
Estate Planning. One of the major benefits of participating in a 1031 exchange is that you can take the tax deferment with you to the grave. If your heirs inherit property received through a 1031 exchange, its value is “stepped up” to fair market value, which wipes out the tax deferment debt. If they decide to sell the property for that same appraised value, there would be NO capital gains tax due to be paid by your heir, as opposed to the 25% – 40% cash you would have had to otherwise pay the government if you sold outright, rather than exchanging. An estate planning attorney should be consulted to take maximum advantage of this opportunity.
In conclusion, the 1031 exchange is a potent instrument in the investor’s toolbox, designed to optimize the growth and sustainability of your real estate portfolio. The frequency of utilizing a 1031 exchange is as flexible as its myriad of benefits. While the concept of swapping one investment property for another may seem straightforward, the intricacies of the tax code and the need for a replacement property of equal or greater value make it imperative to approach each exchange with due diligence and strategic planning. The success of delayed exchanges hinges on meticulous adherence to timelines and regulations. In order to navigate these waters successfully, utilizing a qualified intermediary, as well as a real estate agent with knowledge of the process from start to finish, is beneficial and often essential.
There is no limit to the number of times you can engage in a 1031 exchange. This flexibility allows savvy investors to reinvest in higher-value properties, defer taxes, and expand their real estate ventures. With careful planning and a clear understanding of the rules, the 1031 exchange can be repeated indefinitely, fostering a cycle of growth and prosperity in your investment journey.
WHY SHOULD YOU CHOOSE MICHELLE TO HELP BUY & SELL
YOUR PROPERTY IN A 1031 EXCHANGE?
Immediately after law school, Michelle continued with her educational journey and obtained a Master of Laws in Taxation (LL.M.), thereby deeply expanding her knowledge of the tax code. As a dedicated real estate agent with a legal background as a high-net worth estate planning attorney, Michelle brings a unique understanding and expertise to the intricacies of the rules applicable to a 1031 tax-deferred exchange. While Michelle is no longer a practicing attorney, this combination of experience is an indispensable asset to any investor whose vision is to expand their real estate empire.
ARE YOU AN INVESTOR OR WANT TO BE AN INVESTOR?
Whether you are a seasoned investor with an expansive real estate investment portfolio, or a newbie trying to figure out the ins and outs of investing in real estate, reach out to Michelle for more information, she’s here to help!
**The information provided herein does not, and is not intended to, constitute legal or tax advice; instead, all information on this site is for general informational purposes only. Readers of this site should contact their attorney or C.P.A. to obtain advice with respect to any particular legal or tax matter.