1031 EXCHANGE - OVERVIEW
A 1031 exchange, also known as a like-kind exchange or tax-deferred exchange, is a strategic real estate transaction that allows an investor to defer paying capital gains tax on the sale of an investment property, by using the proceeds to purchase another “like-kind” property.
It gets its name from Title 26, section 1031, of the Internal Revenue Code, which says:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
By utilizing a 1031 exchange, investors can defer taxes and reinvest the proceeds in a new property, which can result in greater purchasing power and more potential for long-term financial growth. However, it’s important to note that this type of transaction must follow specific guidelines and meet certain requirements, which is why it’s crucial to work with a qualified intermediary and consult with a tax advisor or attorney.
At its core, a 1031 exchange can be a powerful tool for real estate investors seeking to optimize their investment portfolio, reduce their tax liability, and achieve their long-term financial goals.
ELIGIBILITY FOR 1031 EXCHANGES
Section 1031 of the tax code permits property owners to postpone paying taxes on the sale of their real estate, provided that the property is held for business or investment purposes. To be eligible for an exchange, the only prerequisite for an individual or entity is that it is a US tax-paying entity. This applies to all taxpayers, such as individuals, partnerships, limited liability companies, S corporations, C corporations, and trusts, regardless of citizenship. It’s important to note that the same taxpayer who sells the relinquished property must also buy the replacement property. The same taxpayer requirement refers to tax identity, not the name on the property’s title. One way to preserve tax identity without owning the property under the taxpayer’s name is to hold it under a “tax disregarded entity,” which is not considered separate from its owner for tax purposes. Examples of tax disregarded entities are a single-member LLC, a trustee of a revocable living trust, or a tenant in common. TIC is a real estate investment vehicle that allows investors to access larger investment-grade real estate than they could on their own. The taxpayer acquires a fractional interest in the property, and the tax gain can be deferred if the tax-deferred exchange requirements are met, and the sale proceeds are reinvested in like-kind property.
1031 EXCHANGE GENERAL REQUIREMENTS
Properties Must Be Exchanged
A sale followed by a purchase does not qualify as a valid exchange under the Internal Revenue Code Section 1031, which stipulates that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, as long as the property is exchanged solely for property of like kind that is also held for productive use in a trade or business or for investment. To meet the requirements of a 1031 exchange, the transaction must be structured and treated as an exchange for tax purposes. This means that a property owner must engage a qualified intermediary (QI) who acts as a facilitator to link the sale to a buyer and the purchase from a seller as a legitimate exchange. The taxpayer must contact the QI before closing the initial sale in a forward exchange or before making the purchase in a reverse exchange.
Held for Business or Investment Purposes
It is crucial to note that both the relinquished property and the replacement property must be held for business or investment purposes to qualify for like-kind exchange treatment. Properties used primarily for personal use such as a primary residence are not eligible for such treatment. Business property need not be replaced with other business property, as it can be replaced with investment property, and vice versa. The scope of real estate held for business or investment purposes extends beyond office buildings. Various types of real property can be used in an exchange, such as agricultural assets, including farmland and ranches, vacant lots for land improvement, conservation easements, and in many cases, even vacation homes used as rental units can be exchanged. This requirement relates to the nature of the property, not its form. Therefore, a wide range of real property types such as farms, ranches, apartment complexes, commercial buildings, or rental homes can be purchased. The essential factor is that it should be used for trade, investment, or business purposes.
No Constructive or Actual Receipt of Exchange Funds
In order to encourage investment continuity and stimulate economic growth, the like-kind exchange serves as a valuable tool. It is important to adhere to the regulations set forth by the IRS which prohibit the taxpayer or their agent from receiving exchange funds or controlling them in any way during the exchange period. This is a critical rule to ensure that constructive or actual receipt of exchange funds does not occur. By following these guidelines, taxpayers are eligible for tax deferral on the funds received from the sale of their property, as these funds are used to purchase new real property rather than for monetary gain.
1031 EXCHANGE TIME LIMIT REQUIREMENTS
In the realm of safe-harbor exchanges, a period of 180 days is permitted for forward, reverse, build-to-suit, or improvement exchanges. The exchange period commences when the relinquished property is sold in a forward exchange and the Qualified Intermediary (QI) retains the proceeds from the sale. Within 45 days of transferring the relinquished property, a taxpayer must identify or acquire the target replacement property. The identification process requires a written document that clearly describes the replacement property, is signed by the taxpayer, and received by the qualified intermediary on or before the 45th day. If the taxpayer identifies a replacement property within the specified time, the taxpayer has the remaining 180 days to acquire the property.
The timeline for a reverse exchange remains the same. In this case, the taxpayer purchases the replacement property first and then has 45 days to identify a property for sale. After the identification period, the taxpayer has 135 days to sell and complete the transaction for their relinquished property.
1031 EXCHANGE IDENTIFICATION REQUIREMENTS
Properties Must Be “Like‐Kind”
Exchanging real estate offers the advantage of being able to swap almost any type of real property with another since they are considered like-kind. The tax code’s definition of “like-kind” pertains to the nature or character of the property, not its quality or class, and is quite liberal in its interpretation. Any real estate is like-kind to any other type of real estate, whether improved or unimproved. Court cases and rulings have further clarified the like-kind standard for real property, and the regulations provide several examples of like-kind real property.
Some examples of real property interests that can be exchanged for any other type of real estate include commercial properties, multi-family rentals, vacant lots, single-family rentals, vacation rentals (Airbnb / VRBO), farm and ranchland, improvements on property not already owned, oil, gas, and other mineral interests, water rights, cell tower, billboard, and fiber optic cable easements, conservation easements, and Delaware Statutory Trusts (DST’s).
It is essential to note that replacement property must be located within the same geographic location as the relinquished property. For a 1031 exchange, there are only two geographic locations – within the US and outside the US. For instance, a taxpayer cannot use the proceeds from a property in Ohio to acquire an investment property in Peru. Property within the US is only like-kind to other property within the US, and property outside of the US is only like-kind to other property outside the US.
Exchange Equal or Up in Value
To defer all taxable gain, property owners must follow two key requirements. First, they must reinvest all the equity in the relinquished property into the replacement property. Second, the purchase price of the new property must be equal to or greater than the sale price of the relinquished property. Typically, this means that the debt on the new property should be equal to or exceed the debt paid off on the relinquished property. The net proceeds from the sale, which are held in the exchange account, are used in full, and the taxpayer takes on equal or greater debt on the new property than the amount paid off during the sale’s closing. In other words, the taxpayer should have “no net debt relief.” Any cash taken out during closing or any uncovered debt may be subject to taxation.
However, in some situations, taxpayers may wish to receive some cash out. Any money received from the sale that is not reinvested is known as “boot,” and this amount is taxable. It is essential to note that boot may arise from many situations, such as taking cash out during closing or purchasing a replacement property that is less expensive than the relinquished property. Proper planning and consultation with a qualified intermediary or tax professional may help minimize the tax impact of boot.
1031 EXCHANGE IDENTIFICATION REQUIREMENTS
The 3-Property Rule
The 3-property rule states that the replacement property identification during the initial 45 days of the exchange can be made for up to three properties regardless of their total value. After relinquishing their initial property, the taxpayer can identify and purchase up to three replacement properties. A qualified intermediary often requires that a taxpayer state how many replacement properties they intend to acquire to prevent common pitfalls surrounding the receipt of excess funds and the early release of funds.
The 200% Rule
If a taxpayer were to identify more than three properties, they could still have a valid exchange by following the 200% rule. The 200% rule states that a taxpayer may identify and close on numerous properties, so long as their combined fair market value does not exceed double the value of their relinquished property. Using the listing price is usually a safe way of determining a fair market value for a property.
The 95% Rule
If the taxpayer has overidentified both previous rules by identifying more than three properties, and their combined value being more than 200% of the relinquished property value, the 95% value comes into play. The 95% rule defines that identification can still be considered valid after breaking the first two rules if the taxpayer purchases through the exchange at least 95% of what they identified.
TYPES OF EXCHANGES
Forward or Deferred 1031 Exchange
In a forward 1031 exchange, the taxpayer and the qualified intermediary (QI) enter into an exchange agreement before any sales transaction. The taxpayer assigns their rights to sell the relinquished property to the QI, who then acts as the seller of the property and holds the funds in an exchange account on behalf of the taxpayer. During the first 45 days of the exchange, the taxpayer must identify potential replacement property, and once a replacement property is selected, the rights to acquire that property are assigned to the QI. The taxpayer must close no later than 180 days after the closing of the relinquished property.
After negotiating the price and executing a purchase contract with the seller of the replacement property, the taxpayer assigns the rights to purchase the replacement property to the QI. The funds held in the exchange account are sent directly to the closing agent, allowing the taxpayer to receive their tax-deferred property and finalize their exchange.
It is important to note that a qualified intermediary plays a crucial role in a 1031 exchange, as they facilitate the transaction and ensure compliance with IRS rules and regulations. They also help to ensure that the exchange meets all the necessary timelines, so taxpayers can enjoy the full benefits of a successful 1031 exchange.
Reverse 1031 Exchange
In situations where taxpayers purchase replacement property before selling their relinquished property, a reverse exchange is necessary. It involves the creation of a specially created entity, commonly known as an exchange accommodation titleholder (EAT), which takes title to the replacement property. When an exchange company is involved in a reverse exchange, it serves as an EAT rather than a qualified intermediary (QI). The taxpayer first enters a contract to purchase the replacement property, and then executes a reverse exchange agreement with the EAT. If the taxpayer is not providing all the necessary funds to purchase the replacement property, they must obtain a loan from a bank and have the EAT purchase the replacement property. The EAT holds the title to the replacement property until the taxpayer sells the relinquished property as part of a conventional forward exchange. After the sale of the relinquished property, the QI holds and disburses the funds to the EAT to complete the purchase of the replacement property. The EAT then repays any financing made by the taxpayer, and the taxpayer takes ownership of the replacement property.
Build-to-Suit or Improvement 1031 Exchange
In certain cases, taxpayers may require a property that they wish to develop or renovate as part of their exchange replacement property. It is important to note that improvements made to land that a taxpayer already owns will not qualify as replacement property in a 1031 tax-deferred exchange.
However, taxpayers can take advantage of a build-to-suit, improvement, or construction exchange to acquire property that meets their specific requirements while deferring taxes. When a replacement property involves land that requires construction or a structure in need of improvement, a build-to-suit or property improvement exchange can facilitate the inclusion of improvement costs in the exchange value of the replacement property. These types of exchanges can occur as forward or reverse exchanges.
For instance, in a forward improvement or construction exchange, the qualified intermediary (QI) holds 1031 proceeds from the sale of the relinquished property under a tax-deferred exchange agreement and assignment agreement. Then, the exchange accommodation titleholder (EAT) utilizes the 1031 proceeds to purchase the property that requires improvement, pursuant to a qualified exchange accommodation agreement (QEAA) between the taxpayer and the EAT. During the 180-day window after the sale of the relinquished property, improvements can be made while the replacement property is parked with the EAT. The transfer of the relinquished property to the QI and the receipt of the replacement property from the QI is considered an exchange and is structured in accordance with IRC Section 1031.
To comply with the IRC Section 1031, it is crucial to structure the transaction appropriately rather than treating it as a sale to one party followed by a purchase from another party. The exchange proceeds may be used to finance the upgrades through draw requests submitted by the taxpayer to the QI and the EAT. If the exchange funds are insufficient, the taxpayer can either provide additional funds to the EAT or secure a loan to meet the necessary costs. In a safe-harbor transaction, the improved replacement property is transferred from the EAT to the taxpayer within 180 days after the sale of the relinquished property.
Non-safe Harbor
Safe harbors refer to the guidelines established by the Internal Revenue Code (IRC), which is a comprehensive set of tax laws created by the Internal Revenue Service IRS) and enacted as Title 26 of the United States Code by Congress. This code covers all relevant rules related to income, gift, estate, sales, payroll, and excise taxes and is organized by topic. The safe harbor rules provide a set of guidelines and a process that must be followed to ensure a valid exchange.
Non-Safe Harbor (NSH) exchanges, on the other hand, do not offer the same level of certainty as safe harbor exchanges in the event of an audit. They are less common and more complex, which increases the risk for the qualified intermediary (QI). A Non-Safe Harbor (NSH) Parking Transaction is defined as a transaction that takes longer than 180 days to close. However, like Safe Harbor Parking transactions, a taxpayer can still complete an NSH Improvement, NSH Build to Suit, NSH Parking of the relinquished property, or NSH Parking of the Replacement property.
For instance, in a forward improvement or construction exchange, the qualified intermediary (QI) holds 1031 proceeds from the sale of the relinquished property under a tax-deferred exchange agreement and assignment agreement. Then, the exchange accommodation titleholder (EAT) utilizes the 1031 proceeds to purchase the property that requires improvement, pursuant to a qualified exchange accommodation agreement (QEAA) between the taxpayer and the EAT. During the 180-day window after the sale of the relinquished property, improvements can be made while the replacement property is parked with the EAT. The transfer of the relinquished property to the QI and the receipt of the replacement property from the QI is considered an exchange and is structured in accordance with IRC Section 1031.
To comply with the IRC Section 1031, it is crucial to structure the transaction appropriately rather than treating it as a sale to one party followed by a purchase from another party. The exchange proceeds may be used to finance the upgrades through draw requests submitted by the taxpayer to the QI and the EAT. If the exchange funds are insufficient, the taxpayer can either provide additional funds to the EAT or secure a loan to meet the necessary costs. In a safe-harbor transaction, the improved replacement property is transferred from the EAT to the taxpayer within 180 days after the sale of the relinquished property.
1031 EXCHANGE VESTING ISSUES – PARTNERSHIP DROP AND SWAP
Inquiries often arise as to whether a partner or member can trade their share of a property interest during a sale. This commonly occurs when some members or partners of a limited liability company (LLC) or partnership wish to engage in a 1031 exchange, while others prefer to receive cash payments. The challenge with structuring an exchange that allows members to go their separate ways is that section 1031 necessitates that properties must be like-kind to one another.
The most widely used approach is known as a “drop and swap,” which involves redeeming the member’s interest. A 1031 tax exchange drop and swap can occur in various ways. If most members wish to cash out, the taxpayer may transfer their membership interest back to the LLC in exchange for a deed for a percentage fee interest in the property equivalent to their former membership interest. At this point, the taxpayer would possess a tenant in common (TIC) interest in the relinquished property together with the LLC. During the closing, each party would provide their deed to the buyer, and the former member could direct their share of the net proceeds to a qualified intermediary. Even if most members desire to complete an exchange, and one or more minority members choose to cash out, the drop and swap technique can still be utilized by dropping applicable percentages of the property to the existing members. Concurrently, the LLC completes an exchange at the LLC level, and the former members cash out and pay the required taxes.
1031 EXCHANGE – SELLING EXPENSES
In a 1031 exchange involving the sale or purchase of an investment property, it’s important to be aware that certain expenses paid from the sales proceeds or 1031 exchange proceeds could trigger a taxable event for the exchanger. Common selling expenses such as broker commissions or title closing fees generally will not create a tax liability. However, it’s worth noting that operating expenses paid at closing from 1031 proceeds can generate a tax liability for the exchanger. It’s crucial to carefully review and consider all expenses related to the transaction to minimize any potential tax consequences.
Allowable closing expenses include:
Real estate broker’s commissions, finder, or referral fees
Owner’s title insurance premiums
Attorney or tax advisor fees related to the sale or the purchase of the property
Closing agent fees (title, escrow, or attorney closing fees)
Recording and filing fees, documentary, or transfer tax fee
Allowable closing expenses include:
Pro-rated rents
Security deposits
Utility payments
Property taxes and insurance
Association’s dues
Repairs and maintenance costs
Insurance premiums
Loan acquisition fees
1031 EXCHANGE – CASH OUT REFINANCE BEFORE OR AFTER THE EXCHANGE?
When completing a 1031 exchange, most taxpayers aim to defer tax in full. To achieve this, a simple rule of thumb is that the taxpayer must trade “up or equal” in value. However, there may be times when a taxpayer wishes to receive some cash out for various reasons. It’s important to note that any cash generated at the time of sale that is not reinvested is considered “boot” and is fully taxable. To gain access to that cash while still receiving full tax deferral, there are a few possible ways to proceed.
Refinancing right before an exchange may seem like a good idea to generate some cash around the time of selling relinquished property. However, this action is viewed unfavorably by the IRS as it can be seen as cheating the system. While there is no bright-line safe harbor for this, if the refinancing is done somewhat before listing the property, it may be helpful. Additionally, the IRS may be less skeptical if there are independent business reasons for the refinance, such as cash flow problems or necessary repairs.
In general, the more time that elapses between any cash-out refinance and the eventual sale of the property, the better for the taxpayer. However, for those who would still like to exchange their property and receive cash, there is another option. The IRS does allow for refinancing on replacement properties. Once a taxpayer owns replacement property and refinances it, incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it, according to the American Bar Association Section on Taxation.
1031 EXCHANGE – SELLER FINANCING IN A 1031 EXCHANGE
In a 1031 exchange, it’s possible to facilitate seller financing of the sale of the relinquished property without violating the exchange rules. When selling real estate, it’s common for the seller (who is the taxpayer in a 1031 exchange) to receive a down payment from the buyer and carry a note for the balance. This financing arrangement is often used when both parties are eager to close the deal, but the buyer’s conventional financing takes longer than expected. If the buyer can secure funding before the taxpayer closes on their replacement property, the note can be substituted for cash from the buyer’s loan.
However, if the taxpayer won’t receive funds in the exchange account before the end of the 180-day exchange period, a note buyout may be necessary. In this scenario, the taxpayer will advance their own funds into the exchange account to “buy” their note. The funds used for the buyout can be personal cash or a loan taken out by the taxpayer. By doing this, the taxpayer can receive fully tax-deferred payments in the future and still acquire their desired replacement property within their exchange window.
It’s important to note that regulations prohibit the taxpayer from having the “right to receive money or other property pursuant to the security or guaranty arrangement.” To avoid any issues, it’s advisable to receive the cash into the account sometime before the purchase of the replacement property and assign the note to the seller after acquiring all of the replacement property.
CONSIDERING A 1031 EXCHANGE?
At 1031Portfolio, we offer our valued clients exclusive access to top-performing investment opportunities. We understand the importance of making informed investment decisions, and we are committed to helping you navigate the complex world of 1031 exchanges with ease. Our in-house brokerage expertise allows us to provide you with the highest level of service and support, ensuring that your investment goals are met.
We encourage you to contact us prior to taking any steps regarding your exchange, as our extensive network of resources, including qualified intermediaries, enables us to provide you with the most up-to-date and reliable information available. Partner with us at 1031Portfolio and let us help you achieve your investment objectives.
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