A 1031 exchange allows investors to defer capital gains tax on the sale of a business or investment property by reinvesting the money into one or more qualifying replacements.
What Is a 1031 Exchange in Real Estate?
A 1031 exchange, which is also sometimes referred to as a ‘like-kind exchange’ or a ‘Starker exchange’, is a feature cited in Section 1031 of the IRS tax code that offers investors a way to defer paying capital gains taxes when disposing of an appreciated investment property that meets certain qualifications.
Note: While the terms ”exchange” and “swap” are frequently used with regard to 1031 exchanges, that does not mean that properties are transferred without monetary compensation. A 1031 exchange involves the actual sale of one property and the actual purchase of another.
1031 Exchange Rules
To qualify as a 1031 exchange, the property and the transaction must adhere to rules and regulations specified by the Internal Revenue Service.
1. Real Estate Properties Rule
First, 1031 Exchanges apply only to real property. The original IRS rules for 1031 exchanges included personal property as well, such as artwork, antiques, boats, aircraft, etc., but on January 1, 2018, personal property no longer became eligible. In addition, only real property itself may be exchanged. Shares in a limited partnership or aReal Estate Investment Trust ((REIT)) do not qualify.
2. ‘Like-Kind’ Exchange Rule
The properties being sold and the replacement purchases must be "like-kind", which means they must be similar in use and value. Generally, any real estate asset counts as “like-kind” to any other, so long as both are held for business or productive use, or as an investment. Any kind of investment property can therefore be considered “like-kind” with any other. So, farmland could be exchanged for apartment buildings, raw land, or commercial property.
According to the IRS, neither quality nor grade matter. For example, a beach condo could be exchanged for a cattle farm. National borders do matter, though, as exchanges are not considered like-kind if one is inside the U.S. and the other is not.
3. Primary Residence vs. Investment Property Rule
Primary residences do not qualify for 1031 exchanges since they are not investment properties. Also, there are separate IRS rules for primary residence sales that allow an exclusion on taxable gains of up to $250,000 for an individual or $500,000 for married couples filing jointly.
Property owners can convert a primary residence into a rental property and become eligible for a 1031 exchange in the future. Similarly, there are rules for converting 1031 exchange investment properties into primary residences. There are also rules for periods when you used a property alternately for a primary residence and an investment property.
Note: The IRS does not specify a minimum holding period to qualify for a 1031 exchange but does suggest that the owner’s intentions for the property when purchased may be considered. Investors with conversions to or from primary residences to investment properties should therefore consult an attorney or tax advisor for assistance.
4. Capital Gains Rule
In order to completely defer any capital gains tax, the fair market value of the replacement properties needs to exceed the fair market value of the relinquished properties. All of the cash proceeds from the sale must be invested in the purchase.
Exchanges defer capital gains but do not eliminate them. However, an investor may defer taxes on capital gains until they pass the properties to heirs upon their death, who may under certain circumstances avoid the gains taxes completely.
Tip: Following an exchange, capital gains may still be due on leftover cash, known as the “boot”. Also, if the new purchase falls through, the investor may be taxed for the entire amount of gains on the relinquished property and if there are multiple 1031 exchanges over many years, the deferred capital gains could result in substantial tax liability.
5. Depreciable Properties Rule
Investors have two depreciation options available with 1031 exchange properties. The IRS preferred method is a “Two schedule” or “Step-in-the-Shoes” depreciation method, which has significant benefits to the investor but can be complex and cumbersome to calculate. In this method, any remaining depreciation from the original property needs to continue on the original schedule.
Investors can opt to use a single schedule methodology for the new property, though it may not be as advantageous to them.
6. Reverse Exchange Rule
Most often, an investor will sell property first and then use the proceeds to purchase the replacement. However, it is permissible to do a “Reverse Exchange”, where the replacement is bought first and the original property sold afterward. Investors are given up to 180 days after the purchase of a replacement to sell the original property.
A Reverse Exchange allows an investor time to implement their exchange in any order, which can help in situations where extra time is needed to consummate a beneficial deal, but it may result in the investor owning both properties for up to six months and that would require that they have sufficient resources to do that.
7. Intermediary Rule
A third-party “qualified intermediary” must be used to ensure that the 1031 exchange is qualified, conducted in accordance with IRS rules, and deemed to represent “arm’s length” transactions where the investor does not transfer ownership to themselves just to avoid taxes.
A qualified intermediary (also known as an exchange facilitator) is a person or company that handles the real estate transactions on behalf of the investor. Qualified intermediaries could be real estate firms, law firms, or other related professionals. This intermediary performs many vital functions:
- Holds the investor’s funds in escrow until the exchange is completed
- Prepares the legal documents for the exchange
- Keeps track of key deadlines
- Ensures that the transactions are completed within IRS rules and regulations
Investors should consider the following qualifications in the selection of an intermediary:
- Real estate experience (including any compliance/registration) examinations
- Objectivity and transparency in financial transactions.
- Security of the funds involved.
Types of 1031 Exchanges
Different types of 1031 exchanges allow investors flexibility as to the timing and nature of transactions. These include:
- Delayed and reverse exchanges: In a reverse exchange, the new property may be acquired before the current one is sold.
- Improvement or ‘build-to-suit’ exchanges: These have provisions for using part of the sale proceeds for the purchase of new property and part for making improvements on that property.
- Partnership 1031 exchanges: such as the Drop and Swap, Swap and Drop, or Split-Off
1031 Tax-Deferred Exchange Timeline
To qualify as a 1031 exchange, you must normally identify the replacement property within 45 days of the sale of the relinquished property and complete your new purchase within 180 calendar days. Delayed or reverse exchanges may have different time frames.
How a 1031 Exchange Works: An Example
Let’s assume Cynthia owns a vacation rental property that has appreciated and she wants to use the proceeds as a down payment on a commercial building closer to where she lives. Her steps for a 1031 exchange would be as follows:
- Step 1: Identify the properties involved in the exchange and make sure they qualify for a 1031 exchange.
- Step 2: Choose A qualified intermediary.
- Step 3: Place her vacation rental up for sale.
- Step 4: Enter into a contract for purchasing the new building within the allotted time frame.
- Step 5: Arrange all necessary financing.
- Step 6: Notify the IRS by filing Form 8824 to specify the properties involved in the exchange, the timeline involved, capital details, and the identities of the various buyers and sellers involved.
Common Uses of a 1031 Exchange
Some of the more common uses for a 1031 exchange are:
- Exchange one investment property for another that appears to have better investment opportunities for the future.
- Utilize gains from an original investment property to buy an additional investment property.
- Exchange an appreciated investment property for multiple properties.
- Combine or consolidate several properties as dictated by estate planning needs.
1031 exchanges allow investors to defer capital gains tax on business or investment properties as long as the proceeds from the sale of the relinquished property are reinvested into the purchase of a replacement property. This provides investors with the ability to reinvest the entire proceeds of a real property sale without having to pay capital gains tax first. Investors must, however, abide by all IRS rules to take advantage of this benefit.
Instructions for IRS Form 8824:Instructions for Form 8824 (2021)
Form 8824: https://www.irs.gov/pub/irs-pdf/f8824.pdf
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