1031 Exchange Simplified
Fundamental rules and concepts
Internal Revenue Code section 1031 allows a business owner or real estate investor to sell/relinquish existing property and acquire a new property as a replacement while deferring tax on the profit of the sale of the sold property. This is the foundational idea for the 1031 “tax-deferred exchanges”.
By using the exchange value in one property and replacing it with another (instead of receiving cash) an investor is simply continuing their investment in the next property. As described in the IRS code, the IRS won’t recognize the sale of the relinquished property as a taxable event, provided that the investor/exchanger/taxpayer follows a series of rules that investors have to govern exchanges.
Note: Investor/exchanger/taxpayer are all the same entity
Note: Sell/relinquish have the same meaning
Let’s total up Lynn’s tax liability:
$37,500 in fed capital gain tax (15% of $250,000)
$8,750 in depreciation recapture (25% of $35,000)
$12,500 in state capital gain tax (5% of $250,000 – your amount depends on your state)
$9,500 in NIIT tax (3.8% of 250,000)
Total tax liability = $68,250
A 1031 Exchange defers taxes, but won’t eliminate them*
Lynn now has the chance to reinvest $68,250 she would otherwise pay in taxes into new and different real estate. She can defer (not eliminate) capital gain, depreciation recapture and a variety of other tax liability. If she someday sells the property that was purchased as the replacement property, she will owe the $68,250 and whatever additional tax liability accrued on the new property she owns.
*Exception: With an unexpected death, a 1031 property with deferred taxes will receive a “step up” in cost basis that eliminates any previously deferred tax burden to the heirs. An investor that dies during an exchange (after the sale and before the purchase) gets special treatment from the IRS. They will allow the estate to continue the exchange to fruition and receive deferral treatment.
Why do I need a Qualified Intermediary (QI) for my 1031 exchange?
Short answer: IRS regulations demand it.
Once you understand the process you will understand the answer to the above question. The most common kind of 1031 exchange is a delayed or commonly called a forward exchange. The exchange process allows the investor to sell relinquished property to a buyer and within 180 days purchase a replacement property.
Essential to the exchange are first, a qualified intermediary (QI) is assigned the investor rights in both the relinquished and replacement property contracts, which allows the taxpayer to “exchange” properties with the QI, as required by Section 1031; and secondly, the QI receives the net proceeds from the sale of relinquished property and uses them as directed by the taxpayer to acquire replacement property. Never is the taxpayer allowed access or influence (constructive receipt) to the funds. This would void the exchange. Thus the QI’s role is essential as directed by the IRS.
Note: If replacement property must be acquired before relinquished property is sold—an increasingly common scenario in today’s tight real estate market—a “reverse exchange,” may be a possibility. We will touch on this topic in other posts.
1031 Exchange Timing Requirements
Following IRS regulations, your 1031 exchange has an identification limit of 45 days and an overall time limit of 180 days. This means your deadline starts the day AFTER the relinquished property sells/closes and your qualified intermediary (QI) deposits your funds from the sale into your escrow account.
You, the investor/exchanger must either acquire or identify the replacement property within 45 days after the sale of the relinquished property. The replacement property to buy must be identified in a written document, signed by the investor, and received by the QI before midnight on the 45th day or sooner. Then you have 135 additional days or sooner to acquire the replacement property (45 days + 135 days = 180 days).
And there is one more thing…The IRC 1031 code requires that your 1031 exchange must be completed within 180 days of your property being relinquished/closed UNLESS your tax filing deadline (April 15th for most taxpayers) occurs first, in which case, your exchange period will instead expire on April 15th. However, you can file a tax extension to make sure you have your full 180 days to complete your 1031 exchange.
Regarding identifying property
You can identify up to three potential replacement properties and purchase any one of them. You can even ID more than three properties as long as the combined fair market value of all identified properties does not exceed 200% of the value of the relinquished property.
If an investor identifies more than three replacement properties and violates this “200% rule,” he or she must close on 95% of the value of all replacement properties, which in most instances means all of them.
Exchanging like-kind property
IRS regulations state that relinquished property must be “like-kind” to the purchased replacement property. In spite of the name like-kind, the properties you are exchanging don’t have to be exactly the same. The replacement doesn’t need to be the same type or quality. In fact, all United States real estate is considered “like-kind” to all other real estate under Section 1031, as long as it has been purchased for business or investment purposes.
An additional benefit is that properties can also be exchanged across state lines. This allows an investor to exchange investment property into a more desirable markets as they see fit. In the above example, Lynn could exchange her Chicago apartment building for an apartment in Florida or an office park in Knoxville or a dude ranch in Colorado.
Note: A single property can be exchanged for multiple properties and the other way around.
Sometimes an investor wants to acquire an interest in multiple member LLC or other partnership that owns real estate as the replacement property. This sort of interest is not like kind and won’t qualify for tax deferral treatment. An investor may invest in fractional interest real estate (tenancy-in-common) or DST (Delaware Statutory Trust) but the replacement property must be real estate, or another interest that qualifies as like-kind, like a leasehold interest longer than 30 years
Qualified Use and Holding Period
Section 1031 makes it clear; an investor must intend to hold both the relinquished and replacement properties for investment or use in a trade or business. It has to be an investment. Primary homes and vacation homes don’t qualify for 1031 exchange treatment, with some limited exceptions. Owning raw land strictly for appreciation in value, even if it generates no income, satisfies the rule, where, conversely, allowing a sibling to rent property for below-market-value rent may bring unwanted attention from the IRS.
How long does an investor have to hold property to qualify for 1031 treatment? The answer is a bit murky. While Section 1031 doesn’t specify the duration, it does bind time and intent together. Several years is usually enough time, even shorter if an investor can demonstrate intent to hold the property when it was purchased. Maybe a surprise cash offer, way over market value caused an investor to sell quickly. This sort of circumstance could excuse an investor from a relatively short holding period.
A developer intending to ‘flip” property following development would not be eligible for 1031 treatment. There was no intent to hold the flipped property.
Qualified Use and Holding Period Same Taxpayer Rule
This rule mandates that the taxpayer who owns the relinquished property must be the same taxpayer who buys and owns the replacement property. Why? If the taxpayer change’s identity, there is no continuity of tax, so an interpretation of IRS regulations suggests that changing tax identity’s part way through the exchange would void it.
Essentially, the taxpayer who owns relinquished property must be the same taxpayer that acquires replacement property.
So, can a taxpayer change ownership structures in a property but maintain their tax identity to successfully complete a 1031 exchange? (Answer: yes).
The taxpayer can be an entity or individual and might not be the party on the deed. For instance, the taxpayer may own property in a living trust, an Illinois-type land trust, or an SMLLC (single-member LLC) all of which are considered “disregarded entities” for tax purposes. This means the entities don’t file their own tax returns but rather their assets are reported on the underlying taxpayer’s tax returns. Essentially, the IRS treats them for tax purposes as if they don’t exist.
If Lynn owned her apartment building in Lynns Real Estate, LLC, a SMLLC and thus disregarded entity, she could acquire replacement property in the same LLC, or use a different SMLLC, or in her individual name, etc.
A tax partnership though has different rules. It is not a disregarded entity; it files its own tax returns and issues a K-1 to each partner/member and accordingly is a distinct tax entity.
If Lynn and her counsin Hannah owned the Chicago apartment building in a two-member LLC called LH Real Estate LLC, the LLC—not Lynn nor Hannah individually would be the taxpayer for exchange purposes. As such, LH Real Estate, LLC would have to acquire replacement property.
If Lynn and Hannah bought the replacement property in their individual names, they would violate the same-taxpayer requirement and invalidate the exchange.
Avoiding Boot, Cash Boot and Mortgage Boot by Trading up with Property of Equal or Greater Value
Note: Cash received or debt paid off that is not offset by new debt or new cash during a 1031 exchange is referred to as “cash boot” or “mortgage boot,” respectively.
To defer 100% taxes on all gain realized from the sale of relinquished property, an investor must buy a replacement property of equal or greater value to the relinquished property AND replace any mortgage debt paid off at closing of the relinquished property with new mortgage debt on the replacement property, or new cash.
Example: If Lynn sells her apartment building for $350,000, she would have to buy replacement property of at least $350,000, regardless of the amount of her net proceeds after debt payoff. If she paid off $100,000 in mortgage debt and only realized $150,000 in net proceeds, she would still have to acquire a $350,000 replacement property and offset the $100,000 mortgage payoff with a new mortgage on her replacement property, or $100,000 of new cash.
Note: Lynn can cash out a portion of the value of her sold property, but would be taxed on that amount, starting with 25% depreciation recapture tax.
Consult With a Knowledgeable QI. As it might appear from the above rules, there are some complexities to successfully completing a 1031 exchange.
This guide is the starting point to introduce you to the basic 1031 exchange requirements.
We are available to discuss your specific situation and to see if an exchange would suit your needs.
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Directrust℠ 1031 exchange services (Directrust℠) performs the duties of a qualified intermediary (QI) and does not provide due diligence to third parties regarding prospective investments, platforms, sponsors, dealers or service providers. Directrust℠ 1031 exchange services does not provide investment, legal or tax advice. Individuals should consult with their investment, legal or tax professionals for such services.