Table of Contents
What Is a 1031 Exchange?
1031 Exchange Rules
What Properties Are Excluded?
How Do You Qualify For 100% Tax Deferral Under a 1031 Exchange?
Can an LLC or Partnership Do a 1031 Exchange?
What Are the Steps For a Delayed 1031 Exchange?
Three Rules For Identifying Replacement Property
Time Is Of the Essence in a 1031 Exchange
NYC 1031 Exchange Bottom Line
What Is a 1031 Exchange?
Typically, when you sell an 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.
1031 Exchange Rules
1. Like-Kind Property
The properties involved in the exchange must be of "like-kind," meaning they must be of the same nature or character, even if they differ in grade or quality. For real estate, almost all real property qualifies as like-kind, including apartments, commercial properties, land, and rental homes.
2. Investment or Business Use
Both the relinquished property (the property sold) and the replacement property (the property acquired) must be held for investment or productive use in a trade or business. Personal residences do not qualify.
3. 45-Day Identification Period
After selling the relinquished property, you have 45 days to identify potential replacement properties. The identification must be in writing, signed by the investor, and delivered to a qualified intermediary or the seller of the replacement property.
4. 180-Day Exchange Period
The exchange must be completed within 180 days of the sale of the relinquished property. This means the replacement property must be purchased and the exchange finalized within this period.
5. Qualified Intermediary
A qualified intermediary (QI) must be used to facilitate the exchange. The QI holds the proceeds from the sale of the relinquished property and uses them to purchase the replacement property. The investor cannot directly receive the sale proceeds.
6. Same Taxpayer
The taxpayer who sells the relinquished property must be the same taxpayer who buys the replacement property. This ensures continuity of ownership for tax purposes.
7. Equal or Greater Value
To fully defer capital gains taxes, the replacement property must be of equal or greater value than the relinquished property, and all proceeds from the sale must be reinvested. Any cash or debt relief received in the exchange is considered "boot" and is subject to capital gains taxes.
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 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.
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.
What Are the Steps For a Delayed 1031 Exchange?
1. List your property for Sale
2. 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.
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 a direct deed from the seller, when the deal closes.
Three Rules For Identifying Replacement Property
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 that 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.
Time Is Of the Essence in a 1031 Exchange
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. That means you need to act quickly if you're performing a 1031 exchange in NYC as it can take months to get board approval and close on a property.
NYC 1031 Exchange Bottom Line
A 1031 exchange offers significant tax deferral benefits for real estate investors in New York, allowing for the reinvestment of capital gains into like-kind properties. Adhering to the federal rules and being mindful of state-specific considerations are essential to successfully executing a 1031 exchange. Engaging experienced professionals and thorough planning are key to navigating the process and maximizing the benefits of this valuable tax deferral strategy.