What is a 1031 Exchange?
Section 1031 of the IRS tax code offers real estate investors one of the last great investment opportunities to build wealth and save taxes. By completing a 1031 Exchange, an investor (taxpayer) can defer the capital gains taxes recognized on selling investment property by reinvesting those proceeds into another like-kind investment property. The regulations that govern 1031 Exchanges are very specific and must be followed to have a successful exchange.
Why Utilize a 1031?
Through a 1031 Exchange, an investor can sell investment property and accomplish several valuable tax and investment goals. Depending on the investor’s circumstances, opportunities may include deferring taxes (up to 35 – 40% of the gain) as well as having greater purchasing power, improved cash flow, portfolio diversification, portfolio consolidation, greater appreciation potential, freedom from joint ownership, geographic relocation (due to a move or to reduce risk due to weather or environmental concerns), estate planning for heirs with a stepped-up basis and more.
1031 Terminology
Boot – The fair market value of any non-qualified (not “like-kind”) property received in an exchange. While receipt of boot will not necessarily disqualify the exchange, an Exchanger who receives boot in an exchange transaction generally recognizes gain to the extent of the value of the boot received. Some common examples of boot are cash, debt relief that is not offset with new debt, property intended for personal use and property which is not like-kind to the Relinquished Property.
Exchanger – The property owner seeking to defer capital gain, recapture or other income tax by utilizing an Internal Revenue Code §1031 exchange.
Like-Kind Property – Properties having the same or similar nature or character, regardless of differences in grade or quality. Generally, all real property located within the United States is considered to be “like-kind” to all other U.S. property as long as the Exchanger’s intent is to hold the properties as an investment or for productive use in trade or business.
Qualified Intermediary – The person or entity that facilitates the exchange for the Exchanger. Although the Treasury Regulations use the term “Qualified Intermediary,” other common terms are “exchange facilitator” or “exchange accommodator”. To be a Qualified Intermediary, the exchange facilitator must not be an agent of the Exchanger.
Relinquished Property – The real property the Exchanger is selling.
Replacement Property – The real property the Exchanger is purchasing.
Key 1031 Guidelines
The 1031 Exchange rules and regulations must be strictly followed for a successful 1031 Exchange. Here are some important highlights:
- Any property involved in an exchange (Relinquished Property and Replacement Property) must have been held for investment or used for productive trade or business use. Primary residences and second homes do not qualify for gain deferral under the 1031 regulations. Property exchanged must be like-kind. For real property exchanges, what constitutes “like-kind” is very broad. A taxpayer can virtually any type of real property for Replacement Property. In other words, a taxpayer can sell a single-family home and purchase an apartment building or sell farmland and purchase a condominium.
- A taxpayer cannot receive cash proceeds (actually or constructively) or other benefits directly from the property sale. To achieve this, the services of a Qualified Intermediary needs to be utilized. The Qualified Intermediary will work with the taxpayer’s advisors and facilitate the entire process of the exchange, including preparing the exchange paperwork, coordinating with the settlement agents and safeguarding and distributing the exchange funds. The Qualified Intermediary must be engaged before the transfer of the Relinquished Property. The Qualified Intermediary cannot be related to the taxpayer or anyone who has acted in a financial or advisory role to the taxpayer like an attorney, CPA, or real estate professional within the last two years. This restriction does not apply if the only services were to facilitate a 1031 exchange in that two-year period.
- There are strict timing deadlines. From the day that the Relinquished Property sale closes, the taxpayer has 45 calendar days to identify Replacement Property and 180 days to acquire the Replacement Property.
- For a complete deferral of taxes, the taxpayer must buy equal or greater in value compared to the Relinquished Property, use all of the proceeds from the sale to acquire Replacement Property and replace the value of debt that existed on the Relinquished Property. Any debt can be replaced with new debt, seller-financing or cash from outside of the exchange.
- Exchange requirements mandate that the same taxpayer that sold the Relinquished Property acquire the Replacement Property. Title to the Replacement Property can be placed in an entity that is disregarded for federal tax purposes, such as a single member LLC.
The Exchange Process – 1031 Exchange Timing is Important
Prior to closing the sale of the Relinquished Property, the Exchanger and the Qualified Intermediary, must enter into an Exchange Agreement which requires the Qualified Intermediary to:
- Acquire the Relinquished Property from the Exchanger and transfer it to the buyer (by direct deed from Exchanger to buyer); and
- To acquire the Replacement Property from the seller and transfer it to the Exchanger (by direct deed from seller to Exchanger).
- Also prior to closing the sale of the Relinquished Property, the Exchanger must assign rights under the Relinquished Property sale contract to the Qualified Intermediary and provide notice of assignment to the buyer.
- At closing, net proceeds from the Relinquished Property sale (“exchange funds”) are paid directly to the Qualified Intermediary, to be held in a separate account for the benefit of the Exchanger until used to purchase Replacement Property.
- The Exchanger has 45 days, from the date the Relinquished Property is transferred, to identify potential Replacement Properties to the Qualified Intermediary or another party permitted by Treas. Reg. §1.1031(k)-1(c)(2).
- Purchase of Replacement Property must be completed by the earlier of the 180th day after transfer of the first Relinquished Property or the due date (including extensions) for filing Exchanger’s tax return.
- Prior to closing the sale of the Replacement Property, the Exchanger must assign rights under the Replacement Property purchase contract to the Qualified Intermediary and provide notice of assignment to the seller.
- The Exchanger authorizes the Qualified Intermediary, to wire funds directly to the closing agent for purchase of Replacement Property, and the settlement agent transfers title directly to the Exchanger, completing the exchange.