What is a 1031 Exchange? Everything You Need To Know

Introduction to 1031 like-kind deferred exchange

A 1031 exchange is a process whereby investors substitute or exchange commercial property for other similar property in their portfolio of holdings – often with the goal of stepping up in property value while deferring any taxes on capital gains during the process. A 1031 can be a simultaneous exchange on the same day, or a deferred “exchange” which can span over 180 days. It is not exactly a trade, but instead includes an actual sale of property and purchasing of other similar property. The purchased property serves as replacement that creates the “exchange”, and is all implemented within a strict time period. Although it’s labeled as “like-kind”, replacement property options include a broader range of options than “like kind” tends to depict.

Who qualifies for a 1031 exchange?

According to the IRS, owners of investment and business property may qualify. This includes individuals, C corporations, S corporations, partnerships, LLCs, trusts, and other taxpaying entities.

How does the 1031 tax deferment work?

If taxes are inevitable, then investors would rather pay them later than pay than now because that money could instead be invested to generate more revenue in the present time. That is essentially what 1031 exchanges allow. As a refresher, capital gains taxes are taxes owed on a person’s or company’s “gain”. This can occur in a number of ways including the sale of owned real estate that has increased in value. Think of “gain” as profit, and profit is – in very general terms – sales price minus cost of goods and expenses (not accounting for depreciated exceptions).

In the case of real property, cost of goods (purchase price) plus improvements would be called your “basis” – the amount an investor has invested in a property. For a simplified example, if an investor purchases a property for $1,000,000 with an additional $100,000 qualified acquisition expenses followed by adding $100,000 of improvements, $1,200,000 is their basis for the property. If the property is later sold for $2,000,000, then the potential taxable gain is $800,000 ($2,000,000 – $1,200,000). If we use a 20% capital tax rate for this example, the result is a $160,000 tax bill ($800,000 x .20). Instead of paying that $160,000 to the IRS at the time of sale, that same $160,000 could instead be used toward more investments in the present time which is what the 1031 accomplishes.

Which types of property qualify for 1031 exchange?

Historically, the 1031 process allowed for personal or intangible property exchanges, but as of the Tax Cuts and Jobs Act, like-kind exchanges are now limited to real property that is not held primarily for sale. If personal or intangible property was disposed of on or before December 31, 2017, the transition rule may still apply to that exchange. As of January 1, 2018, personal property such as machinery, equipment, vehicles, artwork, patents, and IP generally do not qualify. Additionally, primary residences for personal use usually do not qualify because the intention for the deferment is for commercial real estate purposes.

Crucial timelines for like-kind exchanges

The IRS requires that the “exchanging” be performed as an efficient process, and there are no exceptions. A simultaneous exchange will occur in a single day, but a deferred 1031 takes place over a span of time. Here are some non-negotiable timelines for the process. Not adhering to these can result in owing immediate taxes on the gains.

• 45 Days: Owner/seller has 45 days from the closing of the relinquished property to identify the replacement property(s). They are not permitted to acquire properties that have not been identified within this period. If several properties are being sold as part of the exchange, the 45-day deadline starts with the closing of the first relinquished property.
• 180 Days: The purchase process MUST be completed within 180 days from the disposal of the original property, or by the due date for that year’s taxes (whichever comes first). This is extremely important if the 1031 is being implemented toward the end of the year.

How is “like-kind” defined?

While it may be easy to interpret like-kind as “exact match”, that is not the case. The IRS suggests that “like-kind” should be of the “same nature or character even if they differ in grade or quality”. So while it is easy to think that one office building must be exchanged for another, the restrictions are not as such. Examples may include:

• An office building for a warehouse
• Single family rental homes (not personal residences) for apartments
• A retail shopping center for vacant land
• A hotel for a shopping mall

Installing similar debt value

Another important element to implementing a 1031 exchange is the installation of value equal to the debt on the relinquished property. This does not have to be debt, but the value has to be equal. It can be done through the injection of additional cash, private money, seller financing, or traditional financing. For example, if a property sold for $2,000,000 and had $1,000,000 equity, and $1,000,000 debt, then the the $1,000,000 equity has to be rolled into the acquired property, and the $1,000,000 value of debt will need to be replaced with any one or a combination of the sources mentioned.

What is boot in an exchange process?

Remember that an exchange is usually a step up in value. The capital from the disposed property funds the acquisition of the replacement purchased property. But what if the purchased property ends up being LESS that the disposed property? That leaves a surplus from the original sale that is not being reinvested, and that is called “boot”. That portion is then taxed at the capital gains tax rate because it is not being reinvested. A similar result occurs if timelines are not met for the replacement purchase.

QA – Qualified intermediary

One of the most important aspects of a 1031 exchange is that the owner/investor/taxpayer must NEVER take possession of the capital resulting from the disposal of the original property(s). If the taxpayer does take possession of the capital, it no longer qualifies for tax deferment. Capital gains taxes will then be due on any qualifying amounts. The solution is that there be a “qualified intermediary”. One of the responsibilities of this person is the handling of funds, so the taxpayer never has access to, or receives the funds from the property sale. The qualified intermediary also manages the process and helps consult the owner/investor/taxpayer through the process. This person is often an accountant, lawyer, or broker.

What is a reverse 1031 exchange?

While most exchanges occur with the sale of property followed by the acquisition of the replacement real property, it is permissible to implement the exchange in the reverse order. 1031 guidelines allow for the replacement property to be acquired first followed by the relinquishment of property. Timelines must still be followed though. The property being sold must be identified within 45 days, and the closing of that property must be accomplished within 180 days from the closing of the replacement property’s purchase.

Identification of properties

Identifying properties for potential acquisition is a formal part of the 1031 process. It is not simply a suggestion or thought. The identification must be in writing, signed by the investor/taxpayer, and properties must be specifically identified without ambiguity. This identification must be sent to a party involved with the exchange process such as the title company or qualified intermediary (most common).

How many properties can be sold or purchased?

Part of the basis for the exchange is that the relationship between the value of the disposed property and the acquired property(s) must follow the IRS’ guidelines. Here are a few rules for that relationship and how owners may satisfy the exchange requirements.

3 Property Rule

The owner/investor/taxpayer can identify up to 3 replacement properties for acquisition regardless of value as long as they close on at least one of them.

200% Rule

The 200% rule specifies that investors can identify as many properties as they like for replacements as long as the total fair market value does not exceed 200% of the disposed property’s value.

95% Rule

This rule stipulates that the investor can identify more than 3 properties with a total fair market value. This total can 200% of the value of the disposed property, but the owner is required to acquire at least 95% of the value of the properties identified which essentially means the investor MUST purchase everything identified. This lack of flexibility makes this route less popular.

Steps and timeline of a 1031 exchange

• Establish a qualifying intermediary.
• Either sell property(s) intended to be replaced OR acquire replacement property(s) in the case of a reverse exchange.
• Within 45 days, identify replacement property(s), OR which property to relinquish in the case of a reverse exchange.
• Within 180 days of the first closing, close all remaining transactions for the exchange. Note, that it is within 180 days or before the filing date for the year’s taxes. This should be taken into consideration when implementing 1031s toward the end of the year.

FAQs on 1031 Exchanges

Do 1031 exchanges apply to international properties?

No. Qualifying real properties for like-kind exchanges are limited to those located within the United States.

Do stocks or securities qualify for 1031 exchanges?

No. As of the Tax Cuts and Jobs Act, only real property within the United Stats qualifies.

Is a 1031 like-kind tax free?

No. The use of a 1031 only defers capital tax payment obligations. This allows the owner to instead use that capital toward successive investments rather than pay it toward taxes.

Financial advisement for implementing a 1031

There are a number of intricacies involved with 1031 like-kind exchanges including the aspect of depreciated properties. It is always recommended to seek advice from financial professionals who are experienced with the process. Also, be sure to align with the IRS requirements to ensure a successful deferment.