The Basics of 1031s
February 26, 2020
By Jonathan Acquavella
Significant real estate appreciation over the past several years has resulted in many real estate investors holding real property that has the potential for large gains and therefore large tax bills. IRC Sec. 1031 allows taxpayers to defer tax on gains from the sale of certain real property, as long as like-kind property is purchased with the proceeds from the sale of the relinquished property. This strategy is a powerful tool for real estate investors since when it is used to defer taxes, it effectively creates an interest free loan. In certain situations, the potential for a permanent deferral of tax is possible.
In order to effectively utilize an IRC Sec. 1031 exchange, an understanding is needed of the basic requirements, types of IRC Sec. 1031 exchanges including forward and reverse exchanges, and the effects of the Tax Cuts and Jobs Act (“TCJA”) of 2017.
To qualify as an IRC Sec. 1031 exchange, both the relinquished property and replacement property must be “like-kind.” Like-kind is a very broad term which is defined to mean that both the relinquished and replacement properties must be of the same nature or character, even if they differ in grade or quality. A taxpayer can generally exchange almost any type of real property. Examples include an apartment building for land, a single family rental property for a commercial office building, and rental property for a restaurant.
Types of Eligible Real Property
Types of Real Property Not Eligible
Improved real property and unimproved real property
Foreign real property
Portion of a residence that qualifies for business or investment use
A second home/vacation home held strictly for personal use with no rental activity
Vacation homes may be eligible depending on the exchanger’s use and tax treatment of the property
Real property that represents the taxpayer’s stock in trade (i.e., inventory) or other real property held primarily for sale such as developed lots and property held for resale
It should be noted that real property held by a partnership can be sold by the partnership and exchanged for like-kind property. However, a partner in such entity cannot participate in a like-kind exchange with regard to a sale of his or her partnership interest. A partnership interest is not eligible property.
Replacement Property Value Requirements
In order to defer 100% of the tax on the sale of the relinquished property, the fair market value (“FMV”) and equity of the replacement property must be the same as, or greater than, the relinquished property. For example, if a property is sold for $100,000, the purchase price of the replacement property must be equal to or greater than $100,000. Acquisition costs, such as inspections and commissions, count toward the cost of new property. For example, if replacement property is purchased for $95,000, but $10,000 of acquisition costs are incurred, 100% deferral may still be possible if all other requirements are met.
In regard to mortgaged property, it should be noted that the same FMV rule applies regardless of debt. For example, if a property is sold for $100,000 and a mortgage on the property reduces the net proceeds to the seller to $50,000, the cost of the replacement property must still be $100,000 or greater.
A taxpayer is not required to take a mortgage on the new property in order to successfully complete an IRC Sec. 1031 exchange. This is a common misunderstanding about debt in an IRC Sec. 1031 exchange; that the investor must replace 100% of the debt held in the old property by taking on an equal amount of debt against the new property. The solution here is to avoid taxable debt relief which occurs when a mortgage or loan is paid off at the sale of the old property. This debt relief will trigger taxable gain unless:
- exchanger replaces old debt with equal or greater new debt, or
- exchanger increases amount of cash invested in the new property by the amount of debt relief.
Investing additional cash therefore can solve the issue of taxable debt relief. As stated, the purchase price of the new property needs to be equal to or greater than the sale price for the old property. Any decrease in the overall investment amount, whether from taking cash out of the deal or from debt relief, is taxable.
A taxpayer can carry out a partial IRC Sec.1031 exchange, in which the new property is of lesser value, but this will not defer 100% of the tax. This difference is known as “boot,” and is taxable to the extent of gain realized on the exchange. A taxpayer cannot receive boot if they would like to defer 100% of the tax.
Replacement Property Identification and Receipt Requirements
There are a number of identification and receipt rules in an IRC Sec. 1031 exchange. Although a detailed discussion of each of these is beyond the scope of this article, the following key points should be noted:
- Within 45 days of the sale of relinquished property, replacement property must be identified.
- Within 180 days of the sale of relinquished property, replacement property must be acquired.
- Identification options:
- Three properties can be identified without regard to their FMV;
- Any number of properties can be identified as long as their aggregated FMV does not exceed 200% of the FMV of the relinquished property;
- If more properties are identified than allowed under these three-property/200% rules, the IRC Sec. 1031 exchange will only be valid if 1) the replacement property is received by the taxpayer before the end of the 45-day identification period or 2) the FMV of acquired properties is as least 95% of the aggregate FMV of all identified properties.
The name of the seller on its tax return and the name appearing on the title of the property being sold must be the same as the tax return and title holder that acquires the new property. However, there is an exception to this rule for a single member limited liability company (“SMLLC”). A SMLLC can sell the original property, and its sole member may purchase new property in its name or through a new SMLLC.
State Treatment of 1031 Exchanges
It should be noted that Pennsylvania does not follow IRC Sec. 1031 exchange treatment. Furthermore, some states impose a claw-back where the state source of the gain is preserved in the ultimate replacement property. For example, if property is sold in California and replacement property is purchased in Nevada, the original gain will be subject to California tax upon the future sale of the replacement property.
Permanent Deferral Opportunities
An IRC Sec. 1031 exchange can lead to a permanent income tax deferral in some circumstances, such as when a taxpayer never sells replacement property after an IRC Sec. 1031 exchange. When such taxpayer passes away, their heirs will generally inherit the property with a stepped-up basis (i.e., at the FMV of the property at the time of death). A stepped-up basis essentially eliminates the deferred tax.
Types of Exchanges
There are several types of IRC Sec. 1031 exchanges available. Since most sellers are unable to locate exchange counterparties who both own an asset they would like to exchange for and are at the same time looking to acquire the seller’s property as well, a deferred exchange is generally used. In a deferred exchange, a qualified intermediary (“QI”) is used to facilitate and complete an IRC Sec. 1031 exchange. Moreover, the sequence of selling vs. purchasing in an IRC Sec. 1031 exchange is affected by whether a forward or reverse exchange is used.
A forward IRC Sec. 1031 exchange occurs when the relinquished property is sold before the replacement property is purchased. An example of this is when a taxpayer enters into a contract to sell real property. When the property closes and a deferred exchange is used, the QI receives the net proceeds from the transaction. The IRC Sec. 1031 requirements discussed above must then be met by a taxpayer, including the final acquisition of the replacement property. A second closing is scheduled for the replacement property where the funds are wired from the QI, and the forward IRC Sec.1031 exchange is completed.
A reverse exchange occurs when a replacement property is purchased before the relinquished property is sold. The same IRC Sec. 1031 exchange rules apply, albeit in a reverse order (i.e., property to be sold must be identified in 45-day identification period). A reverse exchange is beneficial when a taxpayer unexpectedly finds an investment opportunity that they need to act on before having the time to consider selling property. Also, a taxpayer may simply prefer to buy first to eliminate the pressure of having to identify replacement property within the 45-day identification period.
Implications of the TCJA
Generally for exchanges completed after December 31, 2017, under the TCJA, tax-deferred exchanges under IRC Sec. 1031 are valid only for real property as opposed to other types of tangible property which were allowed in prior years. This provision could have a negative impact on certain exchanges of real property. Gain recognition may occur if a taxpayer gives or receives property that is not like-kind property as part of a larger transaction. Property that is not like-kind property is classified as boot and could create a taxable gain for the taxpayer. One potential solution to this issue is for a taxpayer to look to the significant bonus depreciation options available to mitigate such a gain. For example, the receipt of tangible personal property in an IRC Sec. 1031 exchange may trigger boot and therefore gain; however, the availability of 100% bonus depreciation for used property would create an offsetting deduction. Taxpayers should be aware of the effects of this new provision, and available tax planning strategies, before entering into an IRC Sec. 1031 exchange.
There are many rules and requirements that a taxpayer must comply with in order to complete a successful 1031 exchange. Nevertheless, using a 1031 exchange can be an effective strategy to defer taxes for real estate investors who have properties with significant unrealized gains. Due to the complex requirements including time deadlines, professional guidance is recommended.