Many people invest in real estate because of the potential tax advantages. One such advantage is the ability to make like-kind exchanges under IRC Section 1031. A 1031 exchange can, under certain circumstances, enable investors to defer capital gains and depreciation recapture taxes. The benefits are powerful—but not all investors are sure what 1031 exchanges are or how they work.
In this guide, I’ll bring investors up to speed on the rules and major considerations. I also provide helpful tips for successfully navigating 1031 exchanges.
Before we jump in, it’s critical to note that 1031 exchanges are complex transactions that require hands-on help from a team of experts, including tax advisors, accountants, attorneys, and intermediaries. For the best chances at success, be sure to recruit and coordinate with the right players.
What is a 1031 exchange?
Generally, when an investor sells a business or investment property for a gain, taxes must be paid at the time of sale. IRC Section 1031 provides an exception: It allows investors to postpone paying tax on the gain if they reinvest the proceeds as part of a qualifying like-kind exchange.
How does a 1031 exchange work? Example of a basic forward exchange
The most commonly used type of 1031 exchange is a forward exchange. Forward exchanges are versatile and considered the easiest to implement. In this format, the investor sells the currently owned property (the relinquished property) and then purchases the new property (the replacement property). Investors use a qualified intermediary or another exchange facilitator to hold the proceeds from the sale until the exchange is complete.
These are the basic steps of a forward exchange:
· The investor consults with tax and financial advisors and determines a 1031 exchange is a good fit for their financial goals.
· The investor finds a qualified intermediary, enters into an exchange agreement, and sets up an escrow account.
· When the relinquished property sale closes, the sale proceeds are sent to the escrow account.
· Within 45 days of selling the relinquished property, the investor identifies potential replacement properties.
· Within 180 days of selling the relinquished property, the investor acquires the replacement property, and the exchange is completed.
· When it’s time to close on the replacement property, funds in the escrow account are disbursed.
Alternatively, an investor can complete a reverse 1031 exchange, where the replacement property is acquired before selling the relinquished property.
Benefits of a 1031 exchange
The headline benefit of a 1031 exchange is clear: It grants investors the ability to defer payment of taxes that would otherwise be due when the relinquished property is sold. The deferral is like an interest-free loan from the government.
In addition, investors can enjoy greater purchasing power to acquire the replacement property if they don’t have to immediately pay capital gain taxes on the relinquished property. Instead of paying the IRS, the investor can use the money to identify more or better property.
Lastly, taxpayers can continually defer capital gain taxes by completing one 1031 exchange after another—known as “swap until you drop.” When the exchanger dies, their beneficiaries will enjoy a step-up in basis to fair market value.
The Role of Qualified Intermediaries
If an investor takes control of cash or other proceeds before the exchange is complete, then the transaction may no longer qualify for like-kind exchange treatment and all gains may become immediately taxable. Qualified intermediaries help investors avoid this pitfall by stepping into the middle of the transaction.
Investors should be careful about picking a qualified intermediary, as bankruptcy or lawsuit issues could render the entity unable to meet their obligations to the exchanger. Investors may want to consider the following criteria when selecting a qualified intermediary:
· Experience with the relevant type of exchange
· Transparency into where money is being held, including information about FDIC insurance and any comingling of funds
· Compliance procedures as well as examinations and audits of businesses processes and technologies
Certain people cannot act as exchange facilitators, including persons acting as an agent of the exchanger (e.g., real estate agent, broker, accountant, attorney, employee) or close relations, such as family members and partners.
1031 exchange rules and requirements
Transactions must meet multiple criteria to qualify for tax deferral.
Held for investment or used in trade, business
Both the relinquished and replacement property must be held for investment, or for productive use in a trade or business. “Held for investment” is typically interpreted to mean the property was acquired to be rented, leased, or held for capital appreciation. Holding the property for a certain length of time can help demonstrate it was intended as an investment property, as opposed to being held for sale.
Property used primarily for personal use, such as a primary residence or a vacation home, won’t qualify for like-kind exchange treatment.
The relinquished and replacement property must be of like kind. Like-kind property is property of the same nature, character, or class; quality or grade isn’t important. Given the broad interpretation of like-kind property, investors can typically exchange any one type of business or investment real estate for any other type. For example, a condominium can be exchanged for a shopping center, or an office building exchanged for a single-family home.
The taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property.
For example, if the title to the relinquished property is held by Bob Smith, then the title to the replacement property must also be held by Bob Smith for the transaction to qualify. The same goes for titles held by partnerships or LLCs.
Time limits: 45-day and 180-day rules
Two timing rules must be met for an exchange to qualify for tax deferral. The clock starts when the investor closes on the relinquished property and stops at midnight on the 180th calendar day. The timeline has zero flexibility, except tax relief for disaster victims.
· 45-day rule for identification: The exchanger has 45 days from the date of the sale of the relinquished property to identify potential replacement properties. The identification must describe the property unambiguously, be made in writing, be signed by the exchanger, and be delivered to the qualified intermediary, or another exchange party. A taxpayer may identify as many as three alternate properties of any value. If more than three properties are identified, the value of the three cannot exceed 200% of the value of the relinquished property unless 95% of the properties identified are acquired. Any property that is acquired during the 45-day identification period is deemed to be properly identified.
· 180-day rule for acquisition: The replacement property must be received, and the exchange must be completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as the property identified within the 45-day limit.
Reporting for a 1031 exchange
Investors need to report an exchange to the IRS on Form 8824 and file it with their tax return for the year in which the relinquished property was transferred.
4 tips for successfully navigating 1031 exchanges
1 – Watch out for “boot.”
The value of the replacement property must be greater or equal to the value of the relinquished property—this is part of the “like kind” criteria. If the replacement property is of lesser value than the relinquished property, the shortfall is known as “boot” and is subject to taxation. So, if an investor chooses to cash out some of the proceeds from the relinquished property—a “partial” exchange—the portion left out of the exchange would be taxed.
If an investor has a mortgage on the relinquished property, then the sale proceeds will be less than the value of the relinquished property; however, the value of the replacement property still needs to be greater than or equal to the value of the relinquished property. To avoid taxable boot, investors need to replace the debt from the relinquished property with additional cash or new debt.
2 – Investors can exchange into a DST.
Investors have the option of exchanging into shares of a Delaware statutory trust (DST). DSTs are passive real estate investment vehicles that qualify as real property for the purposes of a 1031 exchange. DSTs are professionally managed by teams who take care of property acquisitions, dispositions, and day-to-day operations. DSTs can be single- or multi-asset; many investors find that multi-asset DSTs offer appealing diversification potential.
3 – Plan ahead to manage the timeline challenges.
Timing tends to be the most difficult roadblock to successfully completing an exchange, so investors would be well served to prepare in advance as much as possible as. If an investor fails to identify a replacement property or close the acquisition in time, they’ll lose their shot at completing an exchange. When timing becomes an issue, some investors turn to DSTs. Others may opt out of the 1031 exchange altogether and choose to defer capital gains taxes through the Opportunity Zone program.
4 – If real estate is owned through an LLC or partnership, special consideration is required.
Taxpayers cannot complete an exchange using partnership interests. (One exception is an interest in a single-member LLC, which is disregarded for tax purposes and treated as if the sole member owns the real estate.) If a partnership or LLC owns real estate and wants to complete a 1031 exchange, then the partnership or LLC is the entity that must complete the exchange—not the individual partners or LLC members.
What if some partners want to exchange and others want to cash out? The American Bar Association suggests three solutions:
· The partnership can dissolve before selling the relinquished property and distribute pro rata shares to the partners. Then, each taxpayer can sell, receive cash, and report a gain, or pursue a 1031 exchange. This is a “drop and swap” strategy where former partners “drop” their ownership interest out of the entity level and become co-owners (tenants in common or TIC) then “swap” using a 1031 exchange.
· The partnership can complete a 1031 exchange and acquire multiple replacement properties and then dissolve. The properties would be distributed to the partners in redemption of their interests.
· The partnership can complete a 1031 exchange, spending less than the exchange value. This creates a recognizable gain that could be specially allocated to the partner who doesn’t want to exchange. Cash would then be distributed to that partner in liquidation of their partnership interest.
The “drop and swap” strategy is not without risk. One area of uncertainty is around the length of time the TIC interest must be held. For taxpayers considering a drop and swap transaction, it’s especially critical to work with a team of experts. They may advise investors to enter into a contractual TIC agreement and pay a pro-rata share of the property’s operating expenses, negotiate a sale agreement individually, and let some time pass while holding the property in TIC interests.
With careful planning and help from the right team of experts, 1031 exchanges can be a powerful tool for real estate investors. Exchanges allow investors to optimize returns by deferring capital gains taxes and maximizing purchasing power—and the taxpayer’s heirs can inherit the property with a basis stepped up to fair market value.