What is a 1031 Exchange, How to Do One, and Everything You Need to Know About the Process
The 1031 exchange is a common and powerful strategy that allows you to defer taxes on capital gains of your real estate investments or business property. It’s used by investors big and small around the country.
It has become an even bigger topic over the last couple years. As real estate prices soar around the country people are looking to take profits off the table and reallocate them with as little tax burden as possible.
But what is a 1031 exchange, how does it work, what are the rules around it, and what are some strategies to use with it?
We’re going to dive into that along with some rules, types of exchanges, and benefits (or pitfalls) of using the 1031 exchange.
TABLE OF CONTENTS
II. When to do a 1031 Exchange
III. How to Do a 1031 Exchange
IV. The Basics of the 1031 Exchange Rules
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We are experienced with 1031 exchanges and all types of commercial real estate assets. Additionally, we offer free consultations with no-pressure and no obligation to work with us and it all starts by setting up a call.
Get guidance from the best 1031 exchange consultants in the industry today.
I. What is a 1031 Exchange?
The 1031 Exchange (also known as a like-kind exchange) is found in section 1031 of the IRS code, hence where the name comes from. According to the IRS a like-kind exchange is:
When you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or “like-kind” -- have long been permitted under the Internal Revenue Code. Generally, if you make a like-kind exchange, you are not required to recognize a gain or loss under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, you must recognize a gain to the extent of the other property and money received. You can’t recognize a loss.
Furthermore, Like-Kind Property is defined as:
Properties are of like kind if they’re of the same nature or character, even if they differ in grade or quality.
Real properties generally are of like kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States.
Simply put, the strategy allows you to defer the payment of capital gains taxes on your investment property so long as you purchase another like-kind property with that profit.
II. When Should I Use a 1031 Exchange?
Every year you earn income on your property and are taxed on it accordingly. But, in addition to that, your property is likely appreciating each year and this profit is not realized until you sell it, so you are only taxed upon sale.
Additionally, the IRS allows you to depreciate the value of the property each year, and then you catch up on those deferred taxes upon sale. This can lead to an even larger and unexpected tax burden if you’ve owned the property for a number of years. This is especially true if you’ve been taking advantage of cost segregation which allows you to speed up your depreciation thus allowing additional depreciation in early years of ownership.
A 1031 exchange may allow you to defer these taxes. You’ll need to speak with an accountant about your specific tax situation to determine if this is the right decision for you. In general, however, our clients love to defer taxes as long as possible.
Everyone will eventually take their cash off the table and pay taxes on it, but deferred taxes allow you to save the tax-money and invest that in the meantime, resulting in you being able to grow your money on a tax-deferred basis. Other investors may hold the property until they eventually pass it on to an heir, which has a whole different set of tax rules which is beyond the scope of this article.
III. How to Do a 1031 Exchange?
Traditionally, a like-kind exchange required a simultaneous swap of similar properties. Realistically, this is extremely rare and difficult to pull off, so that is generally why the majority of exchanges are “delayed” or include a middle-man who holds the cash between the sale of your current property and purchase of your next investment property.
To use the strategy effectively, you must sell one property, take the capital gains from that, and purchase another property with those capital gains. It’s important to note that the IRS like-kind exchange rules require the new mortgage and new purchase price to be equal or higher on the replacement property.
For example, if you sell a $500,000 property and it had a $400,000 loan on it, your new property must have both a purchase price of greater than $500,000 and a mortgage balance of greater than $400,000. We’ll get more into these rules later.
There are 4 kinds of like-kind exchanges that you can do, and you should hire a 1031 specialist to help you determine the best way to accomplish this. Your commercial real estate consultant will be able to provide recommendations for who to work with. We’ll get into the 4 types of exchanges in a moment, but first let’s dive into the rules that govern exchanges.
IV. The Basics of the 1031 Exchange Rules
We all know that nothing is ever simple when the government or taxes are involved. Generally speaking, there are 7 primary rules for a successful 1031 exchange. They are:
Now we’ll dive into each rule.
1) 1031 Exchange Includes Like-Kind Property
To qualify as a 1031 exchange, the old property and the new property must be “like-kind.”
According to the IRS the definition of a Like-Kind property is:
Real properties generally are of like kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States.
In other words, one can’t sell a car and buy a house, sell a house to buy stocks, etc. It’s because they are not the same type of property. For real estate, you can exchange basically any kind of real estate for any other kind, as long as it’s for business or investment purposes.
For example, you could:
exchange a house for an apartment complex, or vice versa.
An office building for a multifamily.
A vacation rental for a strip mall.
NOTE: 1031 Exchanges can include more than two properties. For example, you can sell two houses and combine the equity to purchase a 10-unit building. In essence, you can play ‘Monopoly’ with your property using a 1031 by exchanging 4 green houses for a red hotel.
It can get complex, so make sure you hire a good consulting firm to help you with the process.
2) The 1031 Exchange Is for Investment or Business Purposes Only
As has already been mentioned, you can only use a 1031 for investment or business property. It cannot be used for personal property, even if it’s real property. In the vast majority of circumstances, you cannot sell your home and buy another home, assuming we’re talking about your personal residence.
3) The New Property Has Greater or Equal Value
The IRS requires the market value and the equity of the property purchased to be the same as or greater than the property sold. If it’s not, you will not be able to defer 100% of your tax burden, though you can defer some of it.
Let’s say you have a $1 million property with a loan of $500,000. To get the full tax deferment, the new property has to be worth $1 million and the new loan has to be $500,000 or more. It’s important to note that you can purchase one property or multiple properties where the sum is greater than those figures.
4) Must Not Receive a “Boot”
A “Boot” is the difference between the gain from the property your selling and the amount of cash needed for the property your buying. If you sell a $1 million property and buy a $750,000 property, your boot will be $250,000, and as a result, you will be taxed on this portion.
It’s important to note that you are able to exchange into less valuable properties, but you will be taxed on the gains you don’t use in the exchange to purchase another like-kind property.
5) Must be the Same Taxpayer
The name on the property being sold must be the same as the name on the new property, and the tax returns also must match those names. This is true with one exception which is a single member LLC which is considered a pass-through entity, so it doesn’t apply.
For example, If John Smith owns Main St LLC and sells a property. Then he purchases a new property with an entity named Park Ave LLC. If John Smith is the only owner of both those LLCs, this still qualifies as being the same taxpayer.
6) 45-Day Identification Window
You have 45 days after the sale of your property to identify up to three potential like-kind properties you want to purchase.
This is actually quite difficult as you ultimately need to close on one of the properties you identified. This is true especially in today’s market because many properties in many areas are over-priced and finding good value is a challenge.
An exception to this is known as the 200% rule. In this situation, you can identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.
7) 180 Day Purchase Window
You have to close on the property within 180 days after the sale of your property OR the due date of the income tax return for the tax year which you sold the property. Whichever is earlier.
V. Five Types of Real Estate Exchanges
There are 5 types of 1031 exchanges we will discuss here that include the delayed, reverse, simultaneous, blended, and construction/improvement exchanges.
Each is used for a different purpose, so we’ll break down each and how it’s best used.
1) The Most Common 1031 Exchange – The Delayed Exchange
This is by far the most common type of exchange used by investors today.
This happens when you sell the first property before acquiring the new property.
In other words, the property you currently own (also called the “relinquished” property) is sold first and the property you want to get (the “replacement” property) is purchased second.
You, (the Exchangor) are responsible for the entire transaction before the exchange can be initiated. In other words, you have to market the property, get a buyer, and get a purchase and sale agreement, before initiating the exchange.
Once this has occurred, you then hire a third-party consulting firm and exchange intermediary who then initiates the sale of the property and will hold the proceeds from the sale in a trust while you then work on securing a like-kind property.
Don’t forget about the timing requirements we discussed earlier.
2) Simultaneous 1031 Exchange
We touched upon this in a previous section, but let’s dig into it a little more.
A simultaneous exchange is when the property you sell and the property you are purchasing are closing on the same day. The closings happen simultaneously.
This is a really important caveat. Even a short delay can result in the disqualification of the exchange and have tax consequences.
There are three ways that a simultaneous exchange can happen.
Two parties swap deeds
Three-party exchange. This is where an ‘accommodating party’ facilitates the transfer and does it simultaneously for you.
A simultaneous exchange with a qualified intermediary. In this situation they structure the exchange and walk you through the entire process.
3) Reverse 1031 Exchange
Perhaps the most fascinating form of the 1031 exchange, A reverse 1031 exchange, also known as a forward exchange, occurs when you purchase the replacement property first before selling your current property.
Theoretically, this is an amazingly simple process where you make a purchase then make a sale. But it can be tricky because you are required to make the purchase in all cash and many financial institutions won’t offer a loan for a reverse exchange.
To make things a little more challenging, if you cannot sell your property within 180 days provided by the law, then you will forfeit the exchange entirely.
The reverse exchange follows most of the same rules as the delayed exchange with a few exceptions:
You have 45 days to identify what property is going to be sold as “the relinquished property.”
After the initial 45 days, taxpayers have 135 days to complete the sale of the identified property and close out the reverse 1031 exchange with the purchase of the replacement property
4) Construction or Improvement Exchange
This is a pretty interesting one as well. The construction or improvement exchange allows you to make improvements to the replacement property by using the equity from the exchange property.
In other words. You can use tax-deferred money to improve the new property while it’s in the hands of the intermediary during the 180-day period.
There are 3 additional rules you must follow if you want to defer all of your capital gains.
The equity must be used on improvements or as a down payment by day 180.
The new property must be “substantially” the same as the one you identified. So, a tear-down and rebuild would probably be disqualified.
The value of the property must be equal or greater once you receive the deed back. It’s important to note that the improvements must be in place before you can the property from the intermediary.
5) Blended Exchange
The blended exchange refers to combining different exchange formats into one exchange. This approach allows for further 1031 exchange flexibility, particularly when more than two properties are involved in the exchange. Contact Realty Capital Analytics to speak with our experts and discuss how your 1031 exchange may be structured to accomplish your investment goals.
VI. 1031 Exchange Strategies
There are a lot of strategies for using a 1031 to your benefit, but at their core, they are all about deferring taxes as long as possible. We’ll cover some here, but your best option is to reach out to us directly and discuss some unique strategies for you and your portfolio.
Simple Appreciation Method
This is fairly straight forward and one of the most common strategies. It involves buying a cash-flow positive property that is at or near full value. You purchase it with the intent of having some cash flow, but you are primarily investing because you believe in the long-term potential of the particular area.
You may hold onto it for 5-10 years while accumulating appreciation and also paying down the debt.
At the end of the hold period, you will have a lot of equity that will be taxed upon sale, but you want to level up and buy something bigger or better.
So, you use a 1031 exchange to defer the taxes on the sale and upgrade to something larger.
For example – let us say you purchase a $1 million property and over your hold period it appreciates to $1.5 million.
Additionally, you have depreciated the asset by $250,000 on your taxes over the years, leaving you a total taxable gain of $750,000. Note: it will be a bit more complicated than this; we are just using simple numbers to illustrate the point.
So, the goal is to purchase a property that needs a minimum investment of $750,000 which would give you a purchase price of roughly $3 million if you get a loan at 75% loan to value ($750,000 down payment as 25% down).
In this example, you help an asset for a number of years while receiving cash flow then turned around and bought a property that is worth double to continue the same process.
Add Value Snowball Strategy
This strategy is essentially the same as the simple appreciation method, but on steroids.
Instead of purchasing a property that is at full value, you will focus on finding a property that needs to be improved which should allow you to create additional equity through a rehab, reposition, or through increased rents and decreased operating costs.
Once you have forced the asset to appreciate, you can then sell it and find another property to do this. While this strategy does require more work and effort, you can supersize your portfolio very rapidly because you are held back only by the speed you turn over the assets and the amount of effort you want to put into it.
You can do this with a delayed 1031 exchange and use your own cash for a rehab or improvements, but we’ll use an improvement 1031 exchange as an example: Let us use the previous numbers and you have $750,000 in equity to spend. You could use an improvement 1031 exchange to purchase a property that needs a lot of work.
Let’s say you can find a property that is worth $2 million which requires $500,000 down payment, and you can use $250,000 to rehab or improve the property. After the repairs are complete, let’s say it’s worth $3 million.
In this example, you have the $750,000 cash in equity that you put in, and an additional $750,000 in appreciate that you’ve created through your efforts.
Instead of waiting 5 or 10 years to use the 1031 exchange again, you could turn around and sell it much sooner, then do the same strategy into an even larger property.
Monopoly Method
A 1031 exchange doesn’t have to be used to move from one property into a larger property. You can use the 1031 exchange to sell multiple smaller properties and level up into something much bigger.
Many investors start with single family homes or duplex or triplex style homes. In this example, you may have accumulated 4, 5, or even 10 plus smaller homes.
It would be a bit overwhelming to sell 10 properties and try to buy 10 larger properties. So, you could sell them in groups and use the 1031 exchange to level up. Just like in monopoly when you trade in 4 houses for a red hotel.
It’s important to note that all the timelines begin the moment you sell the first property. So, your 45 day and 180-day windows apply from the moment of the first sale. If you have 10 houses for sale, it may be difficult to close all 10 within the window, so it may be prudent to sell them in smaller groups that are easier to manage. Regardless, it’s important to take note of what you can legitimately sell during your time frame.
Using this method, if you sell 3-4 at a time you could turn your 10-house portfolio into 3 small multifamily properties. If you are able to sell all 10 at once you could jump into one medium size multifamily investment property.
Covid 1031 Play Exchange Strategy
According to CP Executive, many investors are seeking to leave the multifamily market and move into stand alone triple net retail locations. While outside of the scope of this article, it’s worth considering that you can use a 1031 to completely reallocate your portfolio from one type of real estate to another type entirely.
For example, if you have middle to low-income housing which is heavily impacted by rent controls or eviction moratoriums, you can sell those and move to a stand alone Walgreens, KFC, Dollar General, or other recession-resistant retail locations.
High Equity to High Cash Flow Play Exchange Strategy
Many investors on the west or east coasts purchased property a decade or more ago and have seen massive price appreciation. But they’ve also seen their rents as a ratio of price decrease significantly as price growth outstrips rent growth.
Many investors are choosing to sell their coastal portfolios and reallocate to suburban or middle-America portfolios where appreciation will be less substantial, but the return on equity will be substantially higher.
VII. Frequently Asked Questions
What Qualifies as a Like-Kind Exchange?
In order to qualify as a 1031 exchange, the assets must be like-kind and also must be for investment or business purposes. You do not have to buy the same type of property or same quality though.
The term like-kind property refers to two real estate assets of a similar nature regardless of grade or quality that can be exchanged without incurring any tax liability. The Internal Revenue Code (IRC) defines a like-kind property as any held for investment, trade, or business purposes under Section 1031, making them a 1031 exchange. This means both properties involved in the exchange must be for business or investment purposes. Personal residences, therefore, do not qualify as like-kind properties.
What is the 1031 Exchange Timeline?
This depends on the type of exchange used, but in your typical delayed 1031 exchange you have 45 days to identify the replacement property and 180 days to finalize the purchase.
Typically measured from when the relinquished property closes, the Exchangor has 45 days to identify potential replacement properties, and 180 days to acquire the replacement property. The exchange is completed in 180 days, not 45 days plus 180 days.
How long do I Have to Keep a Property I Bought in a 1031 Exchange?
In most cases there is no stipulated minimum, but generally it’s accepted that 12 months is the minimum hold period to avoid tax consequences and issues with the IRS. If you hold it for less, the IRS could say you had no intention of holding it as an investment. You may be required to hold for a minimum of 24 months if you are related parties.
Can I Take Cash Out of a 1031 Exchange?
Yes, but it is subject to capital gain taxes and there is a certain process. Cash can be taken during the sale and funds will be paid directly to you before the 1031 exchange begins.
On the other hand, if the replacement property is of a lower price than the sold property, the difference will be given to you upon purchase and you’ll be subject to your taxes.
If you take out cash during the exchange process, it can invalidate the entire thing.
Can I do a Partial 1031 Exchange?
You are not required to use the entire value of the property you sell. The difference can be kept by you and it is also known as a boot or cash boot. It’s important to note that this money is not deferred and there are rules as to when and how you can take the cash.
How Does Sales Tax Apply?
The 1031 exchange is a system to defer your federal tax liability. You may still be subject to state or municipal taxes. In many instances you can also defer or avoid these as well, but you will need to speak to a professional that can help you navigate your local tax rules.
What About Transfer Taxes?
While the property is technically transferred twice – first to a qualified intermediary, then to you, it is considered a direct transfer. As such you should not be subject to multiple transfer taxes and there is no penalty for having an intermediary.
Can You do a 1031 in a Syndication?
The simple answer is that pooled investments cannot invest using a 1031 exchange because the owners are required to be the same for both the purchase and the sale. So, if you are part of a syndication, you generally cannot make another purchase using a 1031 unless every member and their contributions have not changed.
But, there are a couple ways to invest using a 1031 exchange and also have a pooled investment structure.
Alternately, you can invest using what’s called a TIC, or tenants in common. With this structure you can invest alongside other investors and use a 1031.
Alternately a Delaware statutory trust, or DST is also an acceptable structure for investing using a 1031 exchange.
What is a Delaware Statutory Trust (DST)?
The Delaware Statutory Trust (DST) is a legal entity created and often used in real estate investing that allows for a number investors to pool money together and hold fractional interests in the holdings and assets of the trust.
While there are important legal distinctions, a DST is similar in function to a limited partnership, where a number of partners (or owners) pool investment money together for investment purposes in which a master partner will manage the assets that are owned by the trust. Similar to a limited partnership or LLC, the DST will provide owners with limited liability and pass through income and cash distributions to the minority owners.
The DST has become a widely used structure for pooled real estate investment following a 2004 IRS ruling that allowed ownership interests in the DST to qualify as a like-kind property for use of in a 1031 exchange, which allows sellers of real estate to defer capital gains.
How Does a Delaware Statutory Trust (DST) Work?
Generally speaking, a sponsor will set up the DST and name trustee(s) who will have sole authority to manage the business and assets of the trust. The trustees will have a fiduciary responsibility to the beneficial owners.
The trust will collect the investment money, arrange any financing necessary on behalf of the trust, and make and manage or hire property managers. The trust itself holds direct ownership of the assets with the individual owners owning an interest (or share) in the trust.
Similar to a limited liability company (LLC), all income and distributions are passed through and taxed to the individual owners. The typical life of a trust can vary greatly but could easily be ten years in which property is acquired, income collected and distributed to owners and when, upon disposition of assets, remaining capital is returned to investors.
The trust provides limited liability to the trustees, managers and beneficial owners of the trust, and as a trust rather than an LLC or partnership is very simple and inexpensive for the sponsor to create and operate.
What are the g(6) restrictions, and what does it have to do with the cash I receive?
In an exchange, the taxpayer will not receive proceeds from the sale of a relinquished asset and use those proceeds to buy the replacement asset (that would be a taxable sale, regardless of the like-kind purchase). Rather, the taxpayer is trading with the relinquished assets for the replacement assets and never takes possession of the sale proceeds. Proceeds from the sale of relinquished property are securely held by the exchange company, known as the qualified intermediary ,until they are applied towards the purchase of the replacement asset(s) identified by the taxpayer. The g(6) restrictions provide that the exchange agreement must expressly limit the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash in the account. The regulations further provide if the exchange is unsuccessful after certain timelines pass, all the funds can be returned to the taxpayer.
What are the Related Party Rules?
To prevent the possible abuse of like-kind exchanges, certain persons or entities that are “related” to the taxpayer cannot sell the replacement property to the taxpayer. However, it is permissible for the taxpayer to sell the relinquished property to a related party, generally defined as family members, partnerships in which a common owner owns more than 50% of both partnerships, and corporations in which a common owner owns more than 50% in each.
What are the Required Documents for a 1031 Exchange?
Documents are typically provided by the qualified intermediary and facilitated by your real estate consulting firm. They generally consist of an Exchange Agreement, assignments of certain rights the taxpayer has in the sale and purchase agreements, notices to the seller and buyer of the assignments, and a form to designate the possible replacement properties within the 45 day window.
What are the Notification Requirements?
This is a technicality under the rules. When a taxpayer is transferring ownership of an asset to or from the exchange company, it can be done via an assignment of the taxpayer’s interests under the purchase and sale agreement; however, to perfect this process under the IRS rules, the buyer and seller must receive written notice that this assignment of rights has taken place. Neither the buyer nor seller need to do anything affirmative in connection with providing them notice of the assignment, however it is common to request the buyer or seller provide a signature receipt upon receiving a copy of the notice so that the taxpayer has a simple way of confirming compliance in the event of an audit. Also, the regulations state that all parties to a contract must receive notice of the taxpayer’s assignment of rights. Accordingly, if the taxpayer is one of several sellers or one of several buyers, the additional sellers and buyers should be given notice of the taxpayer’s assignment of rights as well as the taxpayer’s counter party.
What State Regulatory Requirements May Impact My Exchange?
Several states contain regulations regarding the activities of exchange companies in connection with real estate or personal property being sold which is held in that state. Generally, so long as the qualified intermediary is licensed or otherwise in compliance with any applicable state requirements, the taxpayer does not have to be concerned with the regulations affecting the qualified intermediary’s state activities.
There are some states, such as California, which require the qualified intermediary to remit directly to the state’s franchise tax board the sum of 3.3% of any cash left in the exchange account at the conclusion of the exchange. That sum is a down payment on the full capital gain payable to the state. Funds can be left in the account due to a failure to conclude an exchange or due to the fact that the taxpayer used up some, but not all, of the exchange funds. Also, some states have “clawback” rules where a taxpayer may sell relinquished property in the state and acquire replacement property in another state resulting in tax deferral in the first state. Later, if the taxpayer sells the replacement property without a further exchange, the capital gain is payable back to the first state where the relinquished property was sold.
How are Real Estate Taxes Handled in a Like-Kind Exchange?
In an exchange context, relinquished property is transferred from the taxpayer to the qualified intermediary, and from the qualified intermediary to the buyer. Likewise, the replacement property is being transferred from the seller to the qualified intermediary and from the qualified intermediary to the taxpayer. However, the transfer tax that would otherwise be due on the transfers to and from the qualified intermediary do not result in an extra transfer tax. The reason for this is that the regulations allow for a “direct” deed to be given from the taxpayer to the buyer and from the seller to the taxpayer. So for exchange purposes, the properties are deemed transferred to and from the qualified intermediary while for title and transfer tax purposes they are treated as direct transfers from the taxpayer to the buyer and to the taxpayer from the seller.
How is Sales Tax Handled in a 1031 Exchange?
Generally speaking, sales tax due upon the disposition of the relinquished property should be remitted directly from the buyer to the seller, or to the sales taxing authority. Sales proceeds may be used to pay the sales tax due on the purchase of the replacement property, but requires coordination and approval from the taxpayer’s tax advisory professionals.
It’s important to note that the federal law governing like-kind exchanges is focused strictly on income taxation, while sales tax law is typically a state and local matter. However, through careful planning, it is possible to combine the benefits of trade-in treatment with like-kind exchange treatment.
What Issues Are There Surrounding Debt Refinancing?
There is nothing explicit in the regulations on this issue, however it is generally understood that a post-exchange refinance should not affect the validity of the prior exchange. It is recommended that the refinance should not be prearranged prior to the acquisition of the replacement property. For various reasons, absent sound business reasons, it is not recommended to put debt on relinquished property in anticipation of its sale.
What are the rules related to identifying replacement properties?
As the Exchangor, you are required to provide an “unambiguous description” of the potential replacement property on or before the 45th day after closing on the relinquished property. (A legal description or property address will suffice). If you wish to identify or purchase multiple properties, you must follow one of the following guidelines:
Identify up to three properties of any value with the intent of purchasing at least one.
Identify more than three properties with an aggregate value that does not exceed 200% of the market value of the relinquished property.
Identify more than three properties with an aggregate value exceeding 200% of the relinquished property, knowing that 95% of the market value of all properties identified must be acquired.
What if I do an exchange and take money out, or acquire a property of lesser value?
An exchange is not an “all or nothing” proposition. You may proceed forward with an exchange even if you take some money out to use any way you like. You will, however, be liable for paying the capital gains tax on the difference (“boot”).
There’s a common misconception amongst Exchangors on how much money needs to be re-invested when participating in an exchange. In order to be 100% tax deferred, you must re-invest in a property that is equal to or greater than the sales price of the property you are relinquishing. If you choose to go down in value or choose to pull some equity out, an exchange is still possible, but you will have tax exposure on the reduction, or the “boot”.
Is it possible to exchange out of one property into several?
It does not matter how many properties you are exchanging in or out of (1 property into 5, or 3 properties into 2) as long as you go across or up in value, equity and mortgage. The only concern with exchanging into more than three properties is working within the time and identification restraints of section 1031.
What if I want to acquire a property in a different state than the one I’m selling?
Exchanging property across state borders is a very common thing for investors to do. It is important to recognize, however, that the tax treatment of interstate exchanges vary with each state and it is important to review the tax policy for the states in question as part of the decision-making process.
Would I be able to convert an investment property into a primary residence and sell it? What is Section 121?
The IRS realizes that a person’s circumstances may change; therefore, a property may change in character over time. For this reason, it is possible for an investment property to eventually become a primary residence. If a property has been acquired through a 1031 Exchange and is later converted into a primary residence, it is necessary to hold the property for no less than five years or the sale will be fully taxable.
Section 121, the “Universal Exclusion”, allows an individual to sell his residence and receive a tax exemption on $250,000 of the gain as an individual or $500,000 as a married couple. In order to gain this benefit, the investor will need to live in the property for an aggregate of 2 of the preceding 5 years.
After the property has been converted to a primary residence and all of the criteria are met, the property that was acquired as an investment through an exchange can be sold utilizing the Universal Exclusion. This strategy can virtually eliminate a taxpayer’s tax liability and therefore is a tremendous end game for investors.
Can I exchange a domestic property for a foreign one, or vice-versa?
Property located in the United States is not considered “like-kind” to property located in a foreign country. It is not possible to exchange out of the United States into foreign property, and vice-versa.
There has been case law that passed that supports exchanging from the States and into a US territory. There are fourteen US territories: American Samoa, Baker Island, Guam, Howland Island, Jarvis Island, Johnston Atoll, Kingman Reef, Midway Islands, Navassa Island, Northern Mariana Islands, Palmyra Atoll, Puerto Rico, Virgin Islands and Wake Island. It is important to speak with your legal counsel when considering this option.
Section 1031 allows domestic-to-domestic, and foreign-to-foreign.
Can I do a cash-out refinance prior to an exchange?
The whole point of the 1031 Exchange is moving investment money forward to invest in more property. Pulling money out tax free prior to the exchange would contradict this point. For this reason, you cannot refinance a property in anticipation of an exchange. If you do, the IRS may choose to challenge it.
If you wish to refinance your property you will want to make sure the refinance and the exchange are not integrated by leaving as much time in between the two events as possible. You can choose to refinance prior to the property going on the market (6 months to a year) or wait until after the exchange is complete and refinance the newly owned property.
What are the rules for a related party transaction?
A related party transaction is allowed by the IRS, but significantly restricted and scrutinized. The purpose for the restrictions is to prevent Basis Shifting among related parties. Using a third party to circumvent the rules is considered to be a Step Transaction and is disallowed. If your transaction is audited, the IRS will look at the chain of ownership for the property.
The definition of a related party for 1031 purposes is defined by IRC 267b. Related Parties include siblings, spouse, ancestors, lineal descendants, a corporation 50% owned either directly or indirectly or two corporations that are members of the same controlled group.
The restrictions vary depending on whether you are buying from or selling to a related party. The following lists guidelines for each.
Investor selling investment property to a related party:
2-year holding requirement for both parties.
Does not apply where related party also has 1031 Exchange; death; involuntary conversion.
2 years are tolled during the time there is no risk of loss to one of the parties (put right to sell property/call right to buy property/short sale).
Investor buying investment property from a related party:
Related party must also have a 1031 Exchange; or
Taxpayer’s deferment of capital gain is less than or equal to seller’s taxable gain from selling the property.
What’s the difference between sections 1031 and 1033?
Although IRC 1033 and 1031 both allow for the deferment of capital gain on property, the code sections operate and impact the taxpayer differently. IRC 1031 may provide more flexibility on the type of replacement property that can be acquired. IRC 1033 offers more flexibility on time constraints and receipt of funds.
Here is a quick summary of the differences.
IRC 1031
Pertains to the exchange of property used in “trade or business or investment.”
Do not report gain if property is exchanged for “like-kind” property (e.g., real estate for real estate).
A third party intermediary is required.
May not have actual or constructive receipt of sales proceeds from the relinquished property (all funds must be deposited with the exchange-accommodator).
180 days to replace the relinquished exchange property.
45 days to identify replacement property.
Net equity must be reinvested in property of equal or greater value to the relinquished property.
IRC 1033
Pertains to property involuntarily converted or exchanged (destroyed, stolen, condemned or disposed of under the threat of condemnation).
Do not report gain if property received is “similar or related in service or use” to the converted property.
An accommodator is not needed; the deferment is reported on Form 4797.
OK to directly receive payment/proceeds for the involuntary conversion.
3 years to replace real estate; 2 years for other property.No time restrictions during which the replacement property must be identified.
Proceeds must be reinvested in property of equal value to the converted property.
VIII. 1031 Exchange Conclusion
As you’re already aware, real estate is one of the most proven methods to accumulate wealth and achieve passive income. This is great, until it comes time to pay Uncle Sam.
A very common way to defer taxes is through investing in real estate using a 1031 exchange, or like-kind exchange. Using the variety of techniques we laid out in this article, you can take your assets and level up to larger and more profitable portfolios.
It is true though that the 1031 exchange is extremely complicated, even for full-time career investors. Small mistakes can put your tax deferment at risk of being taxed which is why you need to contact a 1031 expert to help you through the process.
At Realty Capital Analytics, we’re expert Real Estate Investment Consultants specializing in the 1031 Exchange Process
We’ve helped countless clients expertly navigate the 1031 Exchange Process and we can help you, too. Reach out for a free, no-obligation consultation to see what strategies are best for you and your business.
Get guidance from the best 1031 exchange consultants in the industry today.