Guide to 1031 Exchanges
Real estate values have increased in recent years, leaving many investors with properties that carry significant unrealized gains and potential tax liabilities.
IRC Sec. 1031 allows taxpayers to defer taxes on these gains by reinvesting the proceeds received from the disposition of real property into “like-kind” property. This strategy acts like an interest-free loan, and in some cases, may even lead to permanent deferral.
To take full advantage of this tax-deferral strategy, investors must understand its basic rules, the types of exchanges, potential pitfalls, and the process for completing a 1031 exchange.
Key Takeaways
- A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting proceeds from the sale of real property held for productive use in a trade or business or for investment, for real property of a like-kind which is to be held for either productive use in a trade or business or for investment. To achieve full deferral, the property received in the exchange must be of equal or greater value.
- To qualify, strict IRS rules must be followed. “Deferred” exchanges, which are discussed below, add additional requirements regarding identifying and closing on the purchase of a replacement property.
- While offering significant tax deferral, wealth building, and estate planning benefits, 1031 exchanges involve complex rules and require professional guidance to avoid pitfalls that could result in a portion of the gain being taxable.
The Basics of 1031 Exchanges
Types of 1031 Exchanges
Benefits of a 1031 Exchange
Potential Pitfalls and Risks of 1031 Exchanges
What are the Steps to do a 1031 Exchange
When to Consult a Professional
The Basics of 1031 Exchanges
What Property is Eligible for 1031 Exchanges
A 1031 exchange involves two key property types:
- Relinquished Property: This refers to the property that the investor “sells” (exchanges) to initiate a 1031 exchange. It is the capital gain resulting from this asset sale that is to be deferred.
- Replacement Property: This is the new, like-kind property that the investor acquires in exchange for the relinquished property. This acquisition completes the exchange and facilitates the tax deferral.
Types of Eligible Real Property
- Improved real property and unimproved real property
- Portion of a residence that qualifies for business or investment use
- Vacation homes may be eligible depending on the amount of personal use by the exchanger and the tax treatment of the property
Types of Real Property Not Eligible
- Personal residence
- Foreign real property (unless exchanged for other foreign real property)
- A second home/vacation home held strictly for personal use with no rental activity
- 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
Note: Real property held by a partnership can be sold by the partnership and exchanged for like-kind property. However, a partnership interest is not considered like-kind property, and a partner in a real-estate owning partnership cannot exchange such an interest for real property or for another real estate partnership interest.
Replacement Property Requirements in a 1031 Exchange
In order to defer 100% of the tax on the gain from 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, that of the relinquished property.
For example, if an investor sells a property for $100,000, the new property (including acquisition costs such as commissions and inspections) must also cost at least $100,000.
1031 Exchange Impacts Mortgages and Debt
Regarding mortgaged property, 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 an equal or higher amount of a mortgage on the relinquished property to complete an IRC Sec. 1031 exchange successfully. However, if the amount of the mortgage relieved exceeds the amount of a new mortgage taken subject to or assumed, the difference, or “boot”, will be taxable gain. This can be avoided if the exchanger increases the amount of cash invested in the new property by the amount of debt relief.
Partial 1031 Exchanges
A taxpayer can engage in a partial IRC Sec. 1031 exchange where the replacement property is of lesser value than the relinquished property. Still, the difference – “boot” is taxable to the extent of gain realized on the exchange.
Key Timelines to Qualify for a 1031 Deferred Exchange
Most 1031 exchanges do not occur simultaneously but are “deferred” exchanges. Special rules must be followed for a deferred exchange to qualify for a 1031 tax deferral.
To qualify for a 1031 exchange, two key deadlines must be met:
- 45-Day Identification Period: The potential replacement properties must be identified within 45 days of selling the relinquished property.
- 180-Day Exchange Period: The closing on the replacement property must occur within 180 days of the original sale date
Missing either deadline disqualifies the exchange and triggers a taxable gain.
Rules for Identifying Replacement Properties
There are specific rules governing how replacement properties can be identified:
- Three-Property Rule: Up to three properties can be identified, regardless of their fair market value, subject to the 200% rule below.
- 200% Rule: Any number of properties can be identified as long as their total fair market value doesn’t exceed 200% of the relinquished property’s fair market value.
- 95% Rule (Escape Hatch): If more properties are identified than allowed under these three-property/200% rules, the exchange will still be valid if 1) the taxpayer receives the replacement property before the end of the 45-day identification period or 2) the fair market value of acquired properties is as least 95% of the aggregate fair market value of all identified properties.
Ownership Requirements
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). An SMLLC can sell the original property, and its sole member may purchase new property in its name or through a new SMLLC.
Role of a Qualified Intermediary (QI)
A Qualified Intermediary (QI), also known as an accommodator or facilitator, is legally required in a deferred 1031 exchange.
In a deferred exchange, the QI:
- Receives and holds the net proceeds from the sale of the relinquished property
- Prepares exchange documents
- Transfers the replacement property to the exchanger
Maintains IRS compliance throughout the process. Use of a QI ensures that the taxpayer does not receive any funds from the sale, which is critical for deferring tax.
Types of 1031 Exchanges
There are several types of IRC Sec. 1031 exchanges. Since most sellers are unable to locate exchange counterparties who both own an asset they would like to acquire and are simultaneously looking to acquire the seller’s property, a deferred exchange is generally used.
The sequence of selling vs. purchasing in an IRC Sec. 1031 exchange is affected by whether a “forward” or “reverse” exchange is used.
Forward Exchange (Standard 1031 Exchange)
In a forward 1031 exchange, the relinquished property is sold before the replacement property is purchased.
After the sale, the QI holds the proceeds, and when the replacement property is found, the QI uses the funds to complete the purchase, finalizing the exchange.
Reverse Exchange
A reverse exchange occurs when a replacement property is purchased before the relinquished property is sold. The same 1031 rules apply, including the 45-day identification period, but now for the property to be sold.
This strategy is useful when:
- A buyer finds an investment opportunity that they need to act on before having the time to consider selling property.
- The investor wants to buy first to avoid pressure during the identification period.
Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) offers investors a way to participate in a 1031 exchange by owning a fractional interest in a larger, institutional-grade property. When an investor sells their relinquished property, they can exchange it for an interest in a DST, which acts as the replacement property.
This allows investors to defer capital gains taxes and participate in a professionally managed real estate asset without the responsibilities of direct property ownership.
Tenancy in Common (TIC) is another method to achieve tax deferral in a 1031 exchange. A TIC interest qualifies as real property for a 1031 exchange. Using a TIC to accomplish a section 1031 exchange frequently occurs when some partners in a partnership desire to engage in a section 1031 exchange and other partners want to “cash out.”
Benefits of a 1031 Exchange
Wealth Building and Portfolio Diversification
Beyond tax deferral, 1031 exchanges are a powerful strategy for wealth building and portfolio diversification. By deferring capital gains, investors can reinvest the full value of their appreciated assets into new, potentially higher-value or higher-income-producing properties.
This allows for a continuous compounding of equity, leading to accelerated wealth accumulation. It also provides the flexibility to strategically shift investment types, for example, moving from raw land to income-producing apartment buildings, or from one geographical market to another, thereby diversifying a real estate portfolio without incurring immediate tax liabilities.
Estate Planning Advantages
An IRC Section 1031 exchange can lead to a permanent income tax deferral in certain circumstances, such as when a taxpayer never sells the replacement property after an IRC Section 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.
Potential Pitfalls and Risks of 1031 Exchanges
Strict Adherence to Rules - The IRS rules governing 1031 exchanges are highly specific and inflexible. Compliance with the 45-day and 180-day timelines are critical.
Transaction Costs - Although the primary benefit is tax deferral, a 1031 exchange still involves various transaction costs (QI, legal, appraisals, closing costs).
Debt Considerations - Paying off debt on the relinquished property without replacing it (with new debt or cash) can result in taxable debt relief.
State Treatment of 1031 Exchanges - Not all states follow federal 1031 rules. For example, Pennsylvania doesn’t recognize 1031 exchanges, and states like California may tax gains later if the replacement property is out of state.
Receiving “Boot” - Any non-like-kind property received—such as cash, reduced debt, or personal property—is considered “boot” and is taxable.
What are the Steps to do a 1031 Exchange
While the specific steps can vary based on the type of exchange, a general overview of the process includes:
- Pre-exchange planning: Due to the complex requirements and strict deadlines, thorough planning with legal, tax, and real estate professionals is essential before initiating an exchange.
- Engaging a Qualified Intermediary: This is a crucial early step. The QI will generally prepare the necessary exchange documents and serve as the neutral party to hold the sale proceeds.
- Selling the relinquished property: Sale proceeds from the relinquished property must be transferred directly to your Qualified Intermediary and never to the exchanging party.
- Identifying replacement property: Within 45 days of selling the relinquished property, potential replacement properties must be formally identified in accordance with the Three-Property Rule, 200% Rule, or 95% Rule.
- Acquiring replacement property: Within 180 days of selling the relinquished property, the closing on the purchase of one or more of your identified replacement properties must occur. The QI will facilitate the transfer of funds.
- Post-exchange considerations: After the exchange is complete, basis and future depreciation must be determined.
Given the complex requirements, strict time deadlines, and potential tax implications of 1031 exchanges, professional guidance is highly recommended.
Experienced legal, tax, and real estate advisors can help maintain compliance with all IRS rules, help with proper property identification, and provide strategic advice tailored to your specific investment goals.
