A Beginners Guide to a 1031 Exchange for Real Estate
Disclaimer: the following is a summary of a 1031 Exchange; it is not meant to be all encompassing as every situation is different. It is therefore recommended you seek the advice of a certified tax professional and/or lawyer before deciding if a 1031 Exchange is right for you.
1031 Exchange Basic Information, Terms and Definitions
The income tax exception known as a 1031 Exchange is defined in Section 1031 of the Internal Revenue Code (IRC).
A 1031 Exchange is also known as a Like-Kind Exchange or a Starker Exchange
- Basis: the purchase price + improvements made – depreciation.
- Boot (taxable): money or other property that is not like-kind and is provided to make up the difference in value between properties exchanged in a 1031 Exchange.
- Depreciation: a reduction in the value of an asset over time because of wear and tear
- Gain (nothing to do with profit): the adjusted sales price (i.e. sales price less deductible expenses such as closing costs) – the basis.
- Relinquished Property: the property that is being sold
- Replacement Property: the replacement property that is being purchased
- Qualified Intermediary (sometimes referred to as an Exchange Facilitator, an Accommodator or an Exchange Accommodation Titleholder – EAT): an unrelated third party that transfers the property and handles the proceeds for the exchange between the relinquished property and the replacement property.
What is a 1031 Exchange?
In basic terms, a 1031 Exchange is the trade or exchange of one investment asset for another which allows the taxpayer to defer or postpone payment of capital gains taxes (typically due at the time of sale), by reinvesting the proceeds into similar property as part of a qualifying like-kind exchange. Stocks, bonds and notes are specifically excluded from qualifying as part of a 1031 Exchange, but real estate is not.
Example: I sell Investment Property A and use the proceeds, without having to pay capital gains taxes, to purchase Investment Property B. In essence, I have reinvested, or rolled, my “gain” from Property A into Property B and won’t be subject to pay the capital gains taxes until/unless I pull the proceeds out of the investment. In the future when I sell Property B, I’ll have the option to again roll or reinvest the gain from properties A and B into a new property (property C or perhaps property C and D).
What is the purpose of a 1031 Exchange?
A 1031 Exchange is one of the most powerful tax deferral strategies available. The primary benefit is it allows the taxpayer to defer paying capital gains taxes by rolling the gain into a qualified like-kind exchange property. A secondary benefit is this provides the taxpayer greater purchasing power for a replacement property. 1031 Exchanges also provide the taxpayer an opportunity to consolidate, diversify and simplify their investment properties.
What is a qualified “like-kind” property for a 1031 Exchange?
A requirement of a 1031 Exchange is, the trade or exchange of one investment asset for another needs to be of “like-kind”. To qualify as like-kind, both the relinquished property and the replacement property must meet certain requirements. One of these requirements is both need to be investment properties therefore a primary or secondary residence (usually) do not qualify as like-kind. Like-kind property is property of the same nature, character or class; quality or grade does not matter. Most real estate will be like-kind to other real estate.
For example, I can sell my rental homes, bare land, office building or apartments and utilizing a 1031 Exchange I purchase/exchange into a Single Tenant Triple Net Lease retail property. I’ve deferred paying capital gains, consolidated my investments and purchased a property that is essentially hassle/headache free.
What are the 1031 Exchange timelines?
The trigger to start the timeline is the sale of the relinquished property. The only exception to extend beyond these timelines is a federally declared disaster so it is critical that the timelines be followed.
45-Day Identification Period: the taxpayer has 45 days to identify the replacement property(ies). Identification is written documentation received by the Intermediary.
180-Day Exchange Period: the taxpayer has 180 days, from the sale of the relinquished property, to complete the purchase/exchange of the replacement property.
Example: on January 1st the relinquished property is sold; 45 days later (Feb 15th) is the deadline to identify the replacement property and 180 days after the sale date (June 30th) is the deadline for completing the purchase/exchange of the replacement property.
What are the identification rules?
Any of the following three rules can be followed, but one of them must be followed.
The Three-Property Rule (typical): identify any three properties regardless of market value. It is recommended you identify three even if you only purchase one.
The 200% Rule: identify any number of properties if the combined fair market value of the properties does not exceed twice (200%) the fair market value of the relinquished property.
The 95% Rule: identify any number of properties provided the taxpayer actually acquires and closes on 95% of the fair market value identified (within the exchange period).
For more detail about 1031 Exchanges, visit the 1031 Exchange Information page. It is also recommended you seek the advice of a certified tax professional and/or lawyer before deciding if a 1031 Exchange is right for you.