1031 Exchanges

Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for investment advice.

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Many understand the basic concept of a 1031 tax deferred exchange but there are many policy nuances that can make this process seem overwhelming. This is an incredible tax tool for investors to consider and I find myself chatting on this topic weekly, which is why I am attempting to outline the basics for colleagues to reference for future use.

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Although used as a verb more than anything else (I’m going to 1031 this property…), 1031 comes from Section 1031 provision in the IRS?tax code. This is also referred to as a like-kind exchange. The ‘like-kind’ is actually a very liberal term and covers almost all real property (real estate). Items that are NOT like kind: debt, bonds, stocks, inventory, securities, trust certificates, partner interest and properties outside the US. But, as an example, a single-family rental would still be considered ‘like kind’ to a commercial retail building.

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This tax provision allows investors to defer their taxes on profits (capital gains) received from the sale of an asset. Defer does not mean tax free, or tax forgiven. It is a current tax break with a later recapture. With this tax tool, investors can sell one or more appreciated assets and defer the payment of their capital gain taxes by acquiring one or more replacement properties.?This tax tool allows investors to keep 100% of their money (equity) working for them, instead of paying (losing) about one-third of their funds to taxes.?

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The Qualified Intermediary (QI), often referred to as the 1031 Exchange Accommodator or the 1031 Exchange Facilitator, will complete the necessary legal documents to ensure that you comply with all laws, regulations, and rulings. Not identifying this entity before the close of escrow is the most common mistake I’ve seen investors make that disqualify them from this process.

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A sticking point for some investors is that to facilitate this tax break one must reinvest all net cash proceeds from the sale of the relinquished property.? Additionally, investors must replace the debt that was paid off on the sale of the relinquished property with an equal amount of debt on the like-kind replacement property.?You can always add more cash into your purchase of your like-kind replacement properties, but you cannot pull any cash out of the sale of your relinquished property without incurring depreciation recapture and/or capital gain income tax liabilities.

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Another point of contention is the ‘qualified use requirement’. The critical issue is that you must have the intent to hold the properties for investment purposes and not have held them for sale (inventory in your real estate business such as a flipper, rehabber, developer or builder).

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There are three different structures for 1031 exchanges. Delayed (or forward) is the most common and might be the only one you have heard of in the past. This is where an investor sells his property first and then meets the time windows to acquire another like-kind property. There is also a reverse (which is exactly that), an investor would purchase the like-kind property prior to selling their relinquished property. And last, there is an improvement option, also called a ‘Build-to-Suit 1031 exchange’.

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The exchange deadlines are something to etch into memory. Investors have 45 calendar days from the close of escrow to identify potential like-kind replacement properties being considered for purchase -and- an additional 135 calendar days (for a total of 180 calendar days) to complete the 1031 exchange by acquiring some or all the identified like-kind replacement properties.

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The last stipulation to this tax code provision is identification requirements. There are three different ways (Rules) that provide investors with flexible options to identify the properties that they intend to close on.

Three Property Identification Rule: The three-property identification rule is the most common rule.? This rule allows investors to identify up to (but not more than) three potential like-kind replacement properties. ?It is highly advisable that investors identify three properties even if their intent is to only acquire one.?

200% of Fair Market Value Identification Rule: Investors can identify more than three potential like-kind replacement properties if the total fair market value of all the potential like-kind replacement properties identified does not exceed 200% of the sales price of the relinquished property/properties.

95% Exception to Identification Rule: Allows investors to identify as many like-kind replacement properties as they wish, provided they acquire and close on 95% of the fair market value identified.

Now that we covered all the policies behind a 1031 exchange, let me answer two questions that I get quite often. If recapture is inevitable, then why do so many investors do 1031 exchanges? Take this from the viewpoint (and benefit) of passing on wealth to children/heirs. There is something called the Step-Up Basis. A step-up in basis resets the cost basis of an inherited asset to its market value on the decedent's date of death. If the asset is later sold, the higher new cost basis would be subtracted from the sale price to calculate the capital gains tax liability, if any. An important variable when talking about generational wealth.

Second most asked question; are there any exceptions to transferring the entire capital gains amount? Yes is the short answer. There is something as a partial 1031 but that is even more specialized and more detailed than I have previously outlined. One important concept to note is the term ‘boot’. Boot refers to any portion of a transaction that doesn't meet the tax-free criteria and thus becomes subject to immediate capital gains tax.

I would highly suggest that you seek counsel before initiating the process to get all details lined up at the forefront, so you don’t miss a compliance aspect that could disqualify you. There is a lot here, but be encouraged and have confidence, many people (not smarter than you), do these transactions all the time. Not a problem, just a process.