Whether you are a new or experienced real estate investor, you’ve probably heard something about a tax-deferred exchange, also known as a 1031 exchange. This tax provision, named after the section of the Internal Revenue Code that codifies it, is an unbelievably valuable financial tool for savvy investors. The federal 1031 exchange tax provision is extremely beneficial to real estate investors who want to decrease their federal tax liability and diversify and increase returns on their investment properties. Below, we will discuss everything you should know about a 1031 exchange transaction.
What is a 1031 Exchange?
In general, when you sell an investment property, you will typically end up owing the Internal Revenue Services (IRS) capital gain taxes, which are the taxes owed on the gross proceeds received from selling property.
A capital gain happens when the sales price of the property is more than the price you paid for the property; this is commonly referred to as the “basis.” In some cases, the basis for the property may change. For example, if you’ve made any improvements to the property, these costs increase your basis. Likewise, if you’ve depreciated the property, this similarly decreases your basis.
In any event, if you sell your property as part of a tax-deferred exchange, you can defer capital gain taxes altogether. Under this provision of the tax code, the IRS allows you to exchange one investment property for another “like-kind” property. This results in no capital gains taxes being owed to the government as part of the transaction.
What is Considered a “Like-Kind” Exchange?
What qualifies as a “like-kind” property, according to the IRS, is actually a generous standard. Notably, any improved or unimproved real property which is owned for use in business and/or investment purposes are eligible to be exchanged in a 1031 Exchange.
For Example:
Vacant Land for a Single-Family Rental
Triplex for retail property
Multifamily apartment building for an Industrial property
Vacant land for a commercial building;
Commercial building for multifamily apartment building
Unimproved property for a commercial building.
However, as is the case with most federal tax provisions, there is a meticulous process that must be followed to ensure that an investor is eligible for the tax benefit.
Notably, there’s no limit on how often an investor can take advantage of a 1031 exchange. Theoretically, an investor can defer capital gains 1000 times and still reap the benefits of a 1031 exchange. In other words, while an investor may have a profit each time the transaction occurs, under a 1031 exchange, the IRS doesn’t recognize the profits until the property is sold for cash.
What properties are excluded?
1) Personal property does not qualify for a 1031 exchange. However, one exception is that when a primary residence is converted to an investment property, held for two (2) out of the last five (5) years. If converted properly, the former personal property may be eligible for a 1031 exchange pursuant to IRC Section 121.
2) Properties held by a business and/or individual with the primary purpose of flipping and reselling and/or dealer property are likewise excluded from 1031 exchange protection.
IRC Section 1031(a)(2)(D) specifically disallows the exchange of partnership interests. However, besides that, most entities qualify for a 1031 exchange. However, the entire entity must relinquish the property, and the entire entity must purchase the replacement property.
How to Receive 100% Tax Deferral pursuant to a 1031 Exchange
To receive 100% tax deferral, investors must do the following:
Reinvest the entire profits (“capital gains”) received from the relinquished property into one or more eligible replacement properties; and
Purchase one or more eligible replacement properties that have the same or greater debt than the relinquished property.
If an investor receives personal property, cash, or any other type of property, this may create a taxable event that is not protected under a 1031 exchange.
Overview of a 1031 Exchange Transaction
For the most part, a 1031 Exchange transaction does not happen simultaneously. In fact, a “delayed exchange” is the most common type of 1031 exchange that investors use. A delayed exchange gives investors/exchangers 180 days to purchase another property. In general, the transaction happens as follows:
Step 1: List the property you plan to relinquish for sale
Step 2: Find a qualified intermediary (QI)
A Qualified Intermediary (QI) is a firm or entity that facilitates tax-deferred exchanges pursuant to Internal Revenue Code section 1031. Overall, a QI ensures that the investor complies with all the rules and regulations to receive the protection of a 1031 exchange. Typically, a QI is insured and bonded against errors and omissions.
Not everyone can serve as a QI. Individuals who are related to the exchanger, or, who has had a financial relationship with the exchanger during the last two years before the date that the escrow is set to close for the transaction, are prohibited from serving as a QI. This restriction includes any employees of the QI. The only exception to this rule is if the QI provided services that were for exchanges “intended to qualify for nonrecognition of gain or loss under section 1031”.
Once you find a QI, you and the QI will sign a written agreement for the 1031 exchange transaction. Pursuant to the agreement, the QI will transfer the relinquished property to the buyer and transfers the replacement property to the investor/exchanger.
Step 3: Sell the Relinquished Property
After the relinquished property is sold, the QI holds the proceeds in a trust or escrow account. This way, the investor never has actual or constructive receipt of the profits from the sale, and the transaction remains eligible to be a part of a 1031 exchange transaction.
Step 4: Identify Replacement Property
The investor/exchanger has 45 days after selling the relinquished property to identify replacement property. Specifically, the exchanger must explicitly describe potential replacement properties (e.g., with a legal description or street address, etc.) in writing to their QI. The 45-day clock begins to run on the date the relinquished property is sold until midnight on the 45th day.
There are three rules for identifying eligible property, which is as follows:
Three Property Rule. An exchanger may identify a maximum of three (3) replacement properties, without regard to the fair market value of the properties.
Two-Hundred Percent Rule. An exchanger may identify an infinite number of properties as long as the cumulative fair market value does not surpass two hundred percent (200%) of the combined fair market value of the relinquished property.
Ninety-Five Percent Exception. An exchanger may identify an unrestricted number of properties without calculating the combined fair market value, as long as the properties acquired add up to at least ninety-five percent (95%) of the fair market value of all identified properties.
Exchangers/Investors who are acquiring real property that is under construction at the time of the acquisition must identify the real property as well as the improvements in as much detail as possible when the identification is made.
Notably, investors who plan on acquiring less than a 100% ownership interest in the replacement property should specify the specific percentage of interest to their QI.
Step 5: Purchase of the replacement property
After the relinquished property is sold, the exchanger/investor has 180 days to purchase and close on an eligible exchange property or properties. The QI will purchase the replacement property (or properties) with the proceeds held in escrow and then transfer the property back to the exchanger via a direct deed from the seller.