6 Keys To Understanding The 1031 Exchange

If you own investment property and are thinking about selling it and buying another property, you should know about the 1031 tax-deferred exchange. This is a procedure that allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax.

Savvy real estate investors know that a 1031 Exchange is a common tax strategy that helps them to grow their portfolios and increase net worth faster and more efficiently than would otherwise be possible. 

So what is a 1031 Exchange, how does it work, what are the different types and how do you avoid common mistakes? In this article, we will explore everything you need to know about the 1031 exchange rules, so read on!

 

Key #1: Understand How the IRS Defines a 1031 Exchange

A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.

Under section 1031, any proceeds received from the sale of property remain taxable. For that reason, proceeds from the sale must be transferred to a qualified intermediary, rather than the seller of the property, and the qualified intermediary transfers them to the seller of the replacement property or properties. 

A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property.

 

Key #2: Identify Properties eligible for a 1031 Exchange

According to the Internal Revenue Service, a property is like-kind if it’s the same nature or character as the one being replaced, even if the quality is different. For example, real estate investors can exchange a small apartment building for a larger apartment project, for an office building, or vacant land. The IRS considers real estate property to be like-kind regardless of how the real estate is improved. 

For active real estate investors, performing 1031 exchanges on properties they’re selling and buying allows them to defer paying capital gains tax and/or eliminate them through estate planning. This maneuver helps investors stay more liquid and redeploy capital gains to scale their real estate portfolios at a more meaningful pace.

But if the IRS’ 1031 Exchange rules aren’t followed to the letter, real estate investors will be liable for capital gains taxes. 1031 Exchanges have a very strict timeline that needs to be followed, and generally require the assistance of a qualified intermediary (QI).

 

Key #3: The Five Common Types of 1031 Exchanges

Five common types of 1031 exchanges are most often used by real estate investors. These are:

• Delayed exchange with one property being sold—or relinquished—and a replacement property (or properties) purchased during the allowed window of time.
• Delayed/simultaneous exchange with the replacement property purchased at the same time the current property is sold.
• Delayed reverse exchange with the replacement property purchased before the current property is relinquished.
• Delayed build-to-suit exchange with the current property replaced with a new property built-to-suit the need of the investor.
• Delayed/simultaneous build-to-suit exchange with the built-to-suit property purchased before the current property is sold.

It’s important to note that investors cannot receive proceeds from the sale of a property while a replacement property is being identified and purchased. Instead, funds are held in escrow by a 1031 exchange intermediary—also referred to as an accommodator—until the replacement property is purchased.

The intermediary cannot be someone who has acted as the exchanger’s agent, such as your employee, lawyer, accountant, banker, broker, or real estate agent. It is best practice however to ask one of these people, often your broker or escrow officer, for a reference for a qualified intermediary for your 1031.

 

Key #4: The Three Important 1031 Exchange Rules

Using a 1031 tax-deferred exchange requires planning. The three primary 1031 exchange rules to follow are:

 

1. Replacement property should be of equal or greater value

 

To make the most of a 1031 exchange, real estate investors should identify a replacement property—or properties—that are of equal or greater value to the property being sold. There are three ways to do this:

• Identify up to three properties regardless of their value.
• Identify unlimited properties as long as the combined value doesn’t exceed 200% of the property being replaced.
• Identify unlimited properties as long as the properties acquired are valued at 95% or more of the property being replaced.

 

2. The replacement property must be identified within 45 days

 

Real estate investors need to plan when doing a 1031 exchange. That’s because the IRS only allows 45 days to identify a replacement property for the one that was sold. But to get the best price on a replacement property experienced real estate investors don’t wait until their property has been sold before they start looking for a replacement. 

Imagine calling a real estate broker who has a property listed for sale and telling them there are only two days left to identify a replacement property. The odds of getting a good price on the property are slim to none.

 

3. Replacement property must be purchased within 180 days

 

The purchase and closing of the replacement property must occur no later than 180 days from the time the current property was sold. Remember that 180 days is not the same thing as 6 months. The IRS counts each day, including weekends and holidays (even federal holidays), to determine the 180-day time frame.

Additionally, real estate with an existing mortgage can also be used for a 1031 exchange. The amount of the mortgage on the replacement property must be the same or greater than the mortgage on the property being sold. If it’s less, the difference in value is treated as boot and it’s taxable.

 

Key #5: How a 1031 Exchange applies in the Real World

Here’s an example of how a 1031 tax-deferred exchange works in the real world. To keep things simple, we’ll assume five things:

• The current property is a multifamily building with a cost basis of $1 million
• The market value of the building is $2 million
• There’s no mortgage on the property
• Fees that can be paid with exchange funds such as commissions and escrow fees have been factored into the cost basis
• The capital gains tax rate of the property owner is 20%

 

Without using a 1031 exchange

 

In this example let’s pretend that the real estate investor is tired of owning real estate, has no heirs, and chooses not to pursue a 1031 exchange. 

When the building is sold the capital gains tax due would be: $2,000,000 sales price minus $1,000,000 cost basis = $1,000,000 profit x 20% capital gains rate = $200,000 + potentially another 3.8% net investment tax on high earners + any additional state capital gains taxes depending on where the property is located. In California, the state capital gains tax liability can be as high as an additional 13.3%, or another $133,000!

 

Using a 1031 exchange

 

Most of us wouldn’t leave $200,000+ on the table. Instead, we’d use a 1031 tax-deferred exchange and follow these steps:

First: Sell the current multifamily building and send the $1M proceeds out of escrow directly to a 1031 exchange facilitator.

Next: Within 45 days from the closing of the sold building identify one or more replacement properties whose total value is at least $2 million – in this case, we’ve found a multifamily building for sale for $2 million, a retail shopping center for $1.5 million, and an apartment building for $2.5 million.

Then: Within 180 days, you could do take any one of the following actions:

• Purchase the multifamily building as a replacement property worth at least $2 million and defer paying capital gains tax of $200,000
• Purchase the second apartment building for $2.5 million and defer capital gains tax of $200,000
• Purchase the retail shopping center for $1.5 million and pay $100,000 in capital gains tax on the taxable gain (or boot) of $500,000
• Purchase the shopping center with another property for a total replacement value of more than $2 million and defer paying capital gains tax

 

Key #6: Eliminating Capital Gains Tax Permanently

1031 exchanges defer—or put off to the future—the payment of accumulated capital gains tax. But what happens when the real estate investor passes away?

When real estate is passed on to an heir, the property is revalued—or stepped up to—its fair market value, and any deferred capital gains taxes are eliminated. This only goes to show that the saying, ‘Nothing is sure except death and taxes is only partly true!

 

The bottom line

 

1031 exchanges allow real estate investors to defer paying capital gains tax when the proceeds from a real estate sold are used to buy replacement real estate. The Internal Revenue Code outlines specific steps investors must follow to qualify for a 1031 exchange:

• Real estate must be used for investment or business purposes
• The replacement property must be identified within 45 days and purchased within 180 days
• If the value of the replacement property is less than the relinquished property, the difference is called boot and it is taxable
• 1031 exchanges can be used even if there is a mortgage on the property
• With proper estate planning, accrued deferred capital gains tax can be eliminated when real estate is passed on to heirs

1031 exchanges are like having an interest-free loan from the IRS. Instead of paying tax on capital gains, real estate investors can put that extra money to work immediately and enjoy higher current rental income while growing their portfolio faster than would otherwise be possible.