If you’re an investor looking to grow your portfolio, 1031 exchanges are something you should know about.
What is a 1031 Exchange?
Defined by the IRS
Simply, 1031 is a tax code that allows an investor to defer capital gains taxes by reinvesting the proceeds of one business or investment asset into another. Through 1031 exchanges, an investor can change the form of the investment without cashing out and being stuck with a hefty capital gains tax bill.
The “1031” comes from federal tax code related to the exchange of property held for productive use or investment. It states, “No gain or loss shall be recognized on the exchange or 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.”
The “exchange” part of the term is actually a misnomer. A 1031 transaction is more of a rollover than an exchange, and sellers can rollover gain and postpone taxes an unlimited number of times. There are a few requirements, though.
According to the Section 1031 exchange, who qualifies?
If you are an owner of business or investment property, then you may qualify for a Section 1031 tax deferral. This includes
- Limited Liability Companies
- Partnerships (general or limited)
- C corporations
- S corporations
- Partnerships (general or limited)
- any other taxpaying entity
If you qualify, then you may set up an exchange of business or investment properties for business or investment properties under Section 1031.
How does a 1031 Exchange Work?
When doing a 1031 exchange, there needs to be an exchange of properties. Basically you will swap one property for another.
What property qualifies for a Like-Kind Exchange?
The property you sell and the replacement property you buy must meet certain requirements. The new investment property in a 1031 exchange must be considered like kind. This relates to the use of the property, and it excludes property strictly held for resale. For example, developers who flip properties won’t qualify under 1031 because their intention is to resell and not invest. Primary residences are also excluded because a 1031 investment isn’t for personal use. Investment properties can always be exchanged for other investment properties, or for vacant land held for investment purposes, however.
Most real estate will be like-kind to other real estate and the tax code vaguely defines “Like-kind” property as property of the “same nature, character or class.” For example, real property that is improved with a residential rental house is like-kind to vacant land. Property within the United States is not like-kind to property outside of the United States.
Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.
Section 1031 does not apply to exchanges of Stocks, bonds, or notes
- Inventory or stock in trade
- Other securities or debt
- Certificates of trust
- Partnership interests
There are time limits here to consider. First, a like-kind exchange doesn’t have to be done simultaneously. However, you must meet two time limits or you will incur a “boot” and 100% of your capital gains will be taxable. These deadlines cannot be extended under any circumstance or hardship except in the case of “presidentially” declared disasters.
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.
The new investment must be identified within 45 days of the closing sale of the old property according to IRS requirements, and the purchase and closing of one or more of the new properties must occur by the 180th day of the closing of the old property.
There are three rules that can be applied to define identification. You need to meet one of the following:
- The three-property rule allows you to identify three properties as potential purchases regardless of their market value.
- The 200% rule allows you to identify unlimited replacement properties as long as their cumulative value doesn’t exceed 200% of the value of the property sold.
- The 95% rule allows you to identify as many properties as you like as long as you acquire properties valued at 95% of their total or more.
The use of a qualified intermediary is required to successfully complete an IRC Section 1031 tax-deferred exchange, in most cases. Example, if you cannot replace the property you sell on the same day, then you need a Qualified Intermediary.
Also know and an Exchange Accommodator or Facilitator, this independent third party, or exchange partner, must hold the proceeds of the sale in a separate account until the purchase of a new property is complete. They also prepares the necessary documents to accomplish the exchange.
If anyone is related to you or who has had a financial relationship with you within the two years, prior to the close of escrow, cannot facilitate your 1031 exchange. This means that you can not use your current attorney, certified public accountant or your real estate agent.
Equal or Greater
Investors who want to defer 100% of the capital gains tax need to make sure that the new property is of equal or greater value than the property being sold, and all of the cash profits must be reinvested. The taxpayer listed on the old property must be identical to the one listed on the new property.
You must also reinvest all of the net cash proceeds from the sale of your relinquished (sold) property AND obtain new debt or invest additional cash equal to the difference between the net purchase price and the reinvested equity. You do not have to replace the debt. You can always invest more cash into the purchase of the like-kind replacement properties if you like. However, the additional cash will essentially become absorbed into the investment property, meaning it cannot be withdrawn without creating a taxable event (unless you refinance the investment property and pull cash out with new debt)
1031 exchanges can protect investors from capital gains taxes and have proven to be a successful way for investors to grow their portfolios and see increased returns on their investments. However, it is important to note that they are complex deals in nature because the tax code has many intricate details. That’s why it’s best to work with a partner who has thorough knowledge of both the exchange process and who knows how to navigate the process seamlessly.
How does a 1031 Exchange Work for my Estate Planning?
A 1031 exchange is a beneficial tool to use in your estate planning. If you hold onto property for life, then you will defer your tax obligation even in passing. If your heirs inherit property received through a 1031 exchange, its value is free of taxes and have a “stepped-up” basis equal to the value of the property at the time of death.
If passing occurs during an exchange, your heirs can complete the exchange and still receive a stepped up basis on the replacement properties. Normally when you sell appreciated real estate, you must pay taxes on the capital gains. And with rates as high as 20%, you would be leaving less money pass on.
Can I 1031 into Fractional Ownership?
Delaware Statutory Trusts (DSTs) and Tenancy in Common (TICs)
Both TICs and DSTs offer 1031 exchange eligible replacement properties in a fractional ownership. Fractional interests allows you to acquire, with other investors, a larger and potentially more stable replacement asset than what you may not be able to acquire and afford on your own:
Benefits of a DST:
- Qualifies as a 1031 exchange
- No Active Management Responsibilities
- Passive Income with Regular Distributions
- No up-front closing costs or capital calls
- Invest the amount you want to invest
- Acquire investment-grade, high-value properties
- Opportunities for diversification
- Heirs Inherit a Stepped-Up Basis
- Non-Recourse Loans
- Easier time meeting Deadlines
- Can be identified as a backup plan
- Eliminate boot
Tenant In Common arrangements provide many of the same advantages to real estate owners who want to participate in a 1031 as DSTs. However, there are some differences and advantages with DSTs.
Here is how do DSTs differ from TICs:
- DSTs does not require unanimous owner approval
- DSTs are financed easier are less expensive
- DSTs have no loan carve-outs
- DSTs offer limited personal-liability
- DST each investor doesn’t need to maintain an LLC
- DST investments have no closing costs
- DSTs have a lower minimum investment
- DSTs do not have trustee term time limits
- DSTs cannot be inadvertently terminated
What are the Potential Risks of TICs?
As with any investment, TICs have certain risks:
- Reliance Upon Others
- Fees and Expenses
- Real Estate Risks