ARTICLES
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Synopsis of the 1031 Exchange
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A 1031 Exchange is a tax deferral strategy that allows an investor to sell a business or investment property and replace it with another like-kind property. Instead of paying capital gains taxes on the sale, the investor can use the funds to acquire a new property and defer the taxes to a future date. However, to take advantage of this wealth preserving and income producing benefit, certain IRS requirements must be met.
Definition of Like-Kind Real Estate - Income Revenue Code 1031(a) defines like-kind properties as those that have been held for productive use in a business or trade or as an investment. Like-kind, as used in this code, means a property that is similar in nature or character, regardless of differences in grade or quality.
Why Should You Do A 1031 Exchange
1031 Exchanges are the most powerful wealth-building tool available to taxpayers. It has been the strategy of countless successful investors. In using the 1031 Exchange, capital gains on the sale of property are deferred or postponed if the IRS rules are accurately followed. This is a wise tax and investment strategy as well as an estate planning tool. In theory, an investor could continue deferring capital gains on investment property until death, potentially avoiding them all together.
1031 Exchange Requirements
Timelines for a 1031 Exchange - the investor must follow the strict 45 to 180-day guidelines for an exchange. Once the exchanger sells the property (relinquished property) they have 45 days to identify property(s) of equal or greater value. Once identified, the exchanger has 180 days from the day they sold their property to acquire the property(s) identified (or 135 days from the end of the 45-day period)
The time-period is not negotiable, includes weekends and holidays, and the IRS will not make exceptions. If you exceed the time limit, your entire exchange can be disqualified, and taxes are sure to follow.
Like-Kind Property in a 1031 Exchange - the investor must acquire like-kind property. Types of replacement properties to identify are:
Exchange Property Held for Investment - the property sold (relinquished property), and the newly acquired property (replacement property) must be held for investment or business purposes.
Equal or Greater Debt and Equity in a 1031 Exchange - if the exchanger sells a property for $1 million, in which $500k was equity and $500k was debt, then the exchanger needs to purchase $1 million or more worth of property. Furthermore, the exchanger needs to use all the equity and replace all the debt to defer 100% of the capital gains taxes.
The exchanger may add additional proceeds to the new purchase if he/she wishes and the exchanger can take on additional debt if desired as well. If the exchanger does not wish to use all the sales proceeds, they may do a partial exchange and pay the applicable capital gains taxes on the difference. This is referred to as boot.
The goal is to trade up to avoid the transfer of ‘boot’ and keep the exchange tax-free.
Constructive Receipt and Qualified Intermediary for a 1031 Exchange - the exchanger may not receive cash from the sale. This is known as ‘constructive receipt’ and would trigger a taxable event on those monies received. According to the IRS safe harbor provisions, the exchanger must use a Qualified Intermediary (QI) to facilitate the 1031 transaction.
The QI is an independent 3rd party who holds the sales proceeds and purchases the replacement property on your behalf. It is extremely important in today's environment to associate only with reputable, insured, and bonded qualified intermediaries.
1031 Exchange Risk - as with any investment in real estate, there are risks associated with Delaware Statutory Trusts and/or Tenants in Common ownership. Risk factors are outlined in the Private Placement Memorandum for each offering. Investors should thoroughly understand all risk factors and discuss them with their financial representative prior to investing in a Delaware Statutory Trust or Tenants in Common Exchange.
Note: The applicable tax codes apply to and relate to federal law only. Individual states may have their own additional tax codes. Please contact the appropriate tax and legal professional in your state.
Types of Like-Kind Real Estate
The relinquished property that is sold must be a qualified property as well as the new replacement property. A property that has been used in the taxpayer’s business or trade, including his/her place of business or office facilities, is a qualified property.
The following are examples of qualified 1031 like-kind properties and like-kind exchanges:
Land as Like-Kind Real Estate
Unimproved raw land held for investment purposes can be exchanged for a rental investment property. Examples are
Note: If specific IRS rules are followed, a 1031 Exchange can help a taxpayer build and preserve wealth and assets, generate cash from the investment, diversify, restructure, and consolidate real estate holdings.
Definition of Like-Kind Real Estate - Income Revenue Code 1031(a) defines like-kind properties as those that have been held for productive use in a business or trade or as an investment. Like-kind, as used in this code, means a property that is similar in nature or character, regardless of differences in grade or quality.
Why Should You Do A 1031 Exchange
1031 Exchanges are the most powerful wealth-building tool available to taxpayers. It has been the strategy of countless successful investors. In using the 1031 Exchange, capital gains on the sale of property are deferred or postponed if the IRS rules are accurately followed. This is a wise tax and investment strategy as well as an estate planning tool. In theory, an investor could continue deferring capital gains on investment property until death, potentially avoiding them all together.
1031 Exchange Requirements
Timelines for a 1031 Exchange - the investor must follow the strict 45 to 180-day guidelines for an exchange. Once the exchanger sells the property (relinquished property) they have 45 days to identify property(s) of equal or greater value. Once identified, the exchanger has 180 days from the day they sold their property to acquire the property(s) identified (or 135 days from the end of the 45-day period)
The time-period is not negotiable, includes weekends and holidays, and the IRS will not make exceptions. If you exceed the time limit, your entire exchange can be disqualified, and taxes are sure to follow.
Like-Kind Property in a 1031 Exchange - the investor must acquire like-kind property. Types of replacement properties to identify are:
- Three properties without regard to their fair market value. (Realistically, most investors follow the three-property rule, so they can complete due diligence and select the one that works best for them that will close.)
- Any number of properties if their aggregate fair market value at the end of the identification period does not exceed 200% of the aggregate fair market value of the relinquished property as of the transfer date.
- If the three-property rule and the 200% rule is exceeded, the exchange will not fail if the taxpayer purchases 95% of the aggregate fair market value of all identified properties.
Exchange Property Held for Investment - the property sold (relinquished property), and the newly acquired property (replacement property) must be held for investment or business purposes.
Equal or Greater Debt and Equity in a 1031 Exchange - if the exchanger sells a property for $1 million, in which $500k was equity and $500k was debt, then the exchanger needs to purchase $1 million or more worth of property. Furthermore, the exchanger needs to use all the equity and replace all the debt to defer 100% of the capital gains taxes.
The exchanger may add additional proceeds to the new purchase if he/she wishes and the exchanger can take on additional debt if desired as well. If the exchanger does not wish to use all the sales proceeds, they may do a partial exchange and pay the applicable capital gains taxes on the difference. This is referred to as boot.
The goal is to trade up to avoid the transfer of ‘boot’ and keep the exchange tax-free.
Constructive Receipt and Qualified Intermediary for a 1031 Exchange - the exchanger may not receive cash from the sale. This is known as ‘constructive receipt’ and would trigger a taxable event on those monies received. According to the IRS safe harbor provisions, the exchanger must use a Qualified Intermediary (QI) to facilitate the 1031 transaction.
The QI is an independent 3rd party who holds the sales proceeds and purchases the replacement property on your behalf. It is extremely important in today's environment to associate only with reputable, insured, and bonded qualified intermediaries.
1031 Exchange Risk - as with any investment in real estate, there are risks associated with Delaware Statutory Trusts and/or Tenants in Common ownership. Risk factors are outlined in the Private Placement Memorandum for each offering. Investors should thoroughly understand all risk factors and discuss them with their financial representative prior to investing in a Delaware Statutory Trust or Tenants in Common Exchange.
Note: The applicable tax codes apply to and relate to federal law only. Individual states may have their own additional tax codes. Please contact the appropriate tax and legal professional in your state.
Types of Like-Kind Real Estate
The relinquished property that is sold must be a qualified property as well as the new replacement property. A property that has been used in the taxpayer’s business or trade, including his/her place of business or office facilities, is a qualified property.
The following are examples of qualified 1031 like-kind properties and like-kind exchanges:
- a hotel for an office building
- commercial property for unimproved property
- an industrial building for a multi-family property
- an office building for a shopping center
- a condo unit for a warehouse
- a farm or ranch for an apartment building
- a duplex for a Tenant in Common (TIC) investment
Land as Like-Kind Real Estate
Unimproved raw land held for investment purposes can be exchanged for a rental investment property. Examples are
- a shopping center for raw land
- undeveloped land for an industrial building
Note: If specific IRS rules are followed, a 1031 Exchange can help a taxpayer build and preserve wealth and assets, generate cash from the investment, diversify, restructure, and consolidate real estate holdings.
1031 Exchanges Are Not for The Do-It-Yourself Investors
This is a basic description of how a successful 1031 Exchange works. Depending upon the taxpayer’s situation, the type of property relinquished, the characteristics of the Replacement Property, and other aspects of the Exchange may be involved. Its completion may become complex and experts should always be consulted.
Using the power of the 1031 Exchange to build and preserve wealth and assets, generate cash flow from investments, restructure, diversify and consolidate real estate holdings is the right of every owner of investment property in the United States. American taxpayers should never have to pay capital gains taxes on the sale of their investment property if they intend to reinvest those proceeds in more investment property.
The information provided is for discussion and information purposes only. It is not intended to replace competent legal, tax or financial planning advice. The applicable tax codes apply to and relate to federal law only. Individual states may have their own additional tax codes. Please contact the appropriate tax and legal professional in your state. This information is provided from sources believed to be reliable but should be used in conjunction with professional advice that is consistent with your personal situation.
Using the power of the 1031 Exchange to build and preserve wealth and assets, generate cash flow from investments, restructure, diversify and consolidate real estate holdings is the right of every owner of investment property in the United States. American taxpayers should never have to pay capital gains taxes on the sale of their investment property if they intend to reinvest those proceeds in more investment property.
The information provided is for discussion and information purposes only. It is not intended to replace competent legal, tax or financial planning advice. The applicable tax codes apply to and relate to federal law only. Individual states may have their own additional tax codes. Please contact the appropriate tax and legal professional in your state. This information is provided from sources believed to be reliable but should be used in conjunction with professional advice that is consistent with your personal situation.
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RPE Category (Digital Digest)
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REAL ESTATE | REGULATIONS | Government / Taxation
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PUBLISHED:
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November 06, 2020
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