What is a 1031 Exchange?
Typically, when you sell investment property, you must pay "Uncle Sam" taxes on the gross proceeds (“capital gains”) of the property. However, if your transaction is part of a 1031 exchange (named after the Internal Revenue Code Section 1031), you can swap out one investment property for another "like kind" property and defer the capital gain taxes altogether (or at the very least pay minimum taxes). When used properly, a 1031 exchange is a powerful tax provision that every savvy real estate investor should become familiar with, that is, unless you enjoy paying taxes.
For starters, there's no limit on how often you can take advantage of a 1031 exchange. Essentially, you can roll over your capital gains 100 times, and even though you technically have a profit, the IRS doesn't recognize the profit until after you sell the property for cash at some point in the future. This tax provision is extremely valuable for real estate investors who want to grow, diversify, and increase returns on their investments.
What types of properties qualify as a like-kind exchange?
A "like-kind" property is a liberal IRS standard. However, don't get too excited, as, with most tax provisions, there are a few caveats, which, if not followed closely, could jeopardize the entire transaction.
What properties are excluded?
- Personal property is not eligible for 1031 exchanges. However, IRC Section 121 provides a tax exclusion for an investor's primary residence held for two (2) of the past five (5) years. When converted properly even a former personal property may be eligible for a 1031 exchange.
- Property held primarily by an entity and/or individual for resale and/or dealer property is also excluded from 1031 exchange transactions.
What types of properties included?
Any real property improved or unimproved, which held for productive use in business or for investment purposes, can be exchanged for one another.
Here are a few examples of qualifying real property for a 1031 exchange:
Unimproved property for commercial building;
Vacant land for a commercial building;
Commercial building for a multi-family apartment building
Duplex for a retail property;
Single-family rental for a multi-family apartment;
Industrial property for rental vacation property in a resort area.
How Do you Qualify for 100% Tax Deferral under a 1031 Exchange?
There are two requirements if an investor wants to conduct a 1031 exchange transaction, which results in a 100% tax deferral. The investor must do the following:
1)Reinvest the entire capital gains from the sale into one or more "like-kind" replacement properties; and
2)Purchase one or more "like-kind" replacement properties, that have the same or a greater amount of debt than the relinquished property.
Please note that If an investor receives cash, personal property or other property in addition to the "like-kind" property, the additional property will probably be taxed.
Can an LLC or Partnership do a 1031 Exchange?
Any entity can do a 1031 exchange, as long as the entire entity relinquishes a property and the entire entity stays intact and purchases a replacement property. However, IRC Section 1031(a)(2)(D) explicitly disallows the exchange of partnership interests.
Do I have to exchange the property simultaneously?
The short answer is No. A "delayed exchange" is the most common type of 1031 exchange. It gives investors 180 days to purchase another property.
What are the steps for a delayed 1031 exchange?
- List your property for Sale.
- Find a qualified intermediary.
A Qualified Intermediary (“QI”), is a company that facilitates Internal Revenue Code section 1031 tax-deferred exchanges. Overall, the QI ensures that all the steps are followed to complete the transaction pursuant to the strict IRS guideline. A QI is typically bonded and insured against errors and omission in the 1031 exchange transaction.
Anyone who is related to the investor, or who has had a financial relationship with the investor within the two years prior to of the exchange cannot serve as the QI (including any employees).
Once you find a QI, you will enter into a written agreement for the transaction. The QI essentially transfers the relinquished property to the buyer and transfers the “like-kind: property to the investor pursuant to the written exchange agreement.
3. Sale of the Relinquished Property
The QI will hold the proceeds from the sale of the relinquished property in a trust or escrow account. This is so that the investor never has actual or constructive receipt of the profits from the sale.
4. Identify like-kind property
Within 45 days of selling your property for a 1031 Exchange, the investor must unambiguously describe (i.e., legal description, street address, etc.) potential replacement properties in writing to the QI. Specifically, the time limit begins on the date the relinquished property is sold until midnight on the 45th day.
The three rules for identifying replacement property are as follows:
Three Property Rule. An investor may designate a maximum of three (3) replacement properties, without regard to the fair market value of the properties.
Two-Hundred Percent Rule. The investor may identify an unlimited number of properties as long as the aggregate fair market value does not exceed two hundred percent (200%) of the aggregate fair market value of the relinquished property.
Ninety-Five Percent Exception. The investor may identify an unlimited number of properties regardless of the combined fair market value, as long as the like-kind properties acquired totals at least ninety-five percent (95%) of the fair market value of all identified properties.
Investors purchasing real property which is being constructed must identify the real property and the improvements in as much detail as possible at the time the identification is made.
Lastly, investors who intend to acquire less than a 100% ownership interest in the like-kind property should specify their ownership interest to the QI.
5. Purchase of Like-Kind Property
You must complete your 1031 exchange by no later than
- midnight of the 180th calendar day after the sale of your property or
- the due date of your Federal income tax return for the tax year in which the relinquished property was sold, including any extensions of time to file, whichever one is earlier.
At closing, the QI purchases the property with the proceeds held in escrow and transfers the property back to the investor by direct deed from the seller, when the deal closes.
Time is of the Essence
Lastly, it is important to remember that time is of the essence in any 1031 exchange. The 45-day deadline for identifying like-kind properties and the 180-day deadline to purchase a like-kind property are both hard deadlines that run concurrently.