If a commercial real estate investor sells a property for a profit, he or she is required to pay capital gains taxes on the amount of the profit. And if the profit (or gain) is large enough, the income tax bill can be significant. Fortunately, there is a way that savvy property owners can defer the tax bill by “exchanging” the sale pr
Every investor knows that one of the key tenets of commercial real estate investing is to build wealth through property appreciation. However, when it comes time to sell an appreciated property, investors can often face a sizable tax bill. Understanding how 1031 Exchanges work can be the answer in this situation, and having knowledge of this tax strategy can be a competitive advantage when investing in commercial real estate.
In this article, we will discuss what a 1031 Exchange is, how it works, and when it can be used to obtain commercial real estate tax deferral benefits. By the end, readers will have all the information needed to determine if a 1031 Exchange is an option for their investment strategy.
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What is a 1031 Exchange?
A 1031 Exchange is a strategy used by commercial real estate investors to defer capital gains taxes on the profitable sale of an investment property by swapping one like-kind investment property for another. The term gets its name from the Internal Revenue Service’s (IRS’s) Internal Revenue Code (IRC) Section 1031.
To fully understand what a 1031 Exchange is and how they work, it is first necessary to understand a handful of key terms.
Key Terms in 1031 Exchanges
The terminology used to discuss and facilitate a 1031 Exchange can be foreign to those unfamiliar with it. To help clear it up, the most important terms are defined below.
Exchange Property
The exchange property is the one that is being sold or “given up.” It is also commonly referred to as the relinquished property.
Replacement Property
The replacement property is the new property purchased as a “replacement” for the relinquished property. Potential replacement properties must be identified within a certain timeframe.
Deferred Exchange
A Deferred Exchange is a type of 1031 Exchange that allows the exchanger to first sell their property (the relinquished property) and then wait a certain period of time before they purchase the replacement property.
Qualified Intermediary
A Qualified Intermediary, or “QI” is a third-party exchange facilitator that works on behalf of their client, the exchanger. They have no interest in the transaction, and their key responsibility is to hold the funds from the exchange property until the replacement property is selected. The qualified intermediary then releases the funds for the replacement property and ensures all IRS requirements are met.
Like-Kind Property
Under IRS rules, a “Like Kind Property” is one that is of the same “nature or general character” to the property being sold. It does not necessarily refer to its physical quality. As a general rule, most commercial properties are like-kind to other commercial properties.
Identification Period
The “identification period” is a period of time that starts when the relinquished property is sold, and extends for 45 days, during which time the exchanger must formally identify the replacement property they plan to purchase.
Exchange Period
The exchange period is another period of time that starts when the relinquished property is sold and extends 180 days. During this period, the investor must acquire the replacement property.
Net Proceeds
Net proceeds refers to the amount of money received by the seller as a result of the sale of the exchanged property. This amount must be reinvested in the replacement property and is calculated as the selling price, less any outstanding loan balances, less any customary selling expenses.
In-Cash
In-cash refers to the point in time when an investor has closed out the escrow on the exchanged property and is in the 45-day identification period. The funds from the sale of the exchanged property are being held with a qualified intermediary, waiting to be reinvested in a replacement property.
Direct Deeding
A direct deeding transaction is one where the exchanged property or a replacement property is directly deeded to a buyer, and not to a qualified intermediary first.
Disqualified Person or Individual
Disqualified person or individual refers to a seller’s relatives or agents. Including family members, personal or family attorneys, and personal or family accountants.
Boot
Boot is cash or other non like-kind property given by one party to another. When received, it is taxable.
1031 Exchange Rules & Guidelines: What You Need to Know
1031 Exchanges have strict regulations and guidelines that must be followed to be considered a valid exchange. Therefore, it is important to be well-versed in these rules to take advantage of the associated tax deferral benefits.
Like-Kind Properties Rule
The like kind rule has evolved over the years to include the exchange of properties that may not fall in the same asset class but are designated for business or investment purposes alike. For example, an apartment building may be exchanged with an industrial warehouse so long as both of the properties are used for investment purposes or in a trade or business. The major exclusions investors should be aware of are primary residences, foreign assets for domestic assets, and exchanging physical property for financial assets such as stocks or bonds.
Three-Property Rule
The three-property rule states that investors can identify up to three potential properties to buy as long as they close on at least one of them. However, the 200% Rule and 95% Rule are exceptions and are discussed below.
200% Rule
As an exception to the Three-Property Rule, the 200% Rule stipulates that an investor can identify an unlimited number of replacement properties, so long as their combined fair market value does not exceed 200% of the value of the exchanged property. For example, if an investor sells a property for $500,000, they could identify ten replacement properties with fair market values of $100,000 each.
95% Rule
Under the 95% Rule an investor can identify any number of replacement properties with an unlimited, total fair market value, so long as they buy 95% of the aggregate value of those properties. For example, if an investor sells a property for $500,000, they can identify five properties worth a total of $3,000,000, so long as they buy 95% (or $2,850,000) of the identified fair market value.
45-Day Time Limit
There is a strict 45-day time limit during which the investor must identify one or more replacement properties. As discussed above, this timeline begins when the sale of the relinquished property is closed and includes weekends and holidays.
180-Day Deadline
After the sale of the relinquished property is complete and escrow is closed, investors have 180 days to close on one or more replacement properties.
What is Not Allowed In a 1031 Exchange
If a property has already closed before the investor discovers that a 1031 Exchange could benefit them, it is unfortunately too late to utilize the exchange. In addition, primary residences are excluded, and domestic-to-foreign exchanges are not permitted.
Types of 1031 Exchanges
There are four common types of 1031 Exchanges: two-party simultaneous exchanges, delayed exchanges, reverse exchanges, and construction-related exchanges.
Two-Party Simultaneous Exchange
In a Two-Party Simultaneous Exchange, two property owners agree to swap deeds and the ownership interest in their properties. This is the oldest form of 1031 Exchange. However, in modern times it’s very difficult to find fair-market-value properties with similar debt and equity structures, which can make this type of exchange challenging.
Delayed Exchange
Delayed Exchanges are by far the most common form of 1031 Exchanges. These are the exchanges in which there is a “delay” between the time the relinquished property is sold and the replacement property is purchased.
As described above, the 45 day rule states that investors have 45 days from the date of sale to identify a suitable replacement property and 180 days to close on the purchase of it.
Reverse Exchange
A reverse exchange occurs when an investor acquires a like-kind replacement property prior to fully relinquishing ownership of the exchanged property. Since individuals cannot simultaneously have ownership in the replacement property and the exchanged property, they must utilize an Exchange Accommodation Titleholder (EAT), to temporarily take possession of one of the properties via a special purpose entity (like an LLC).
Construction or Improvement Related Exchanges
Under this exchange method, investors can make improvements on a replacement property using their equity generated from the exchanged property. While these improvements can significantly enhance the value of the replacement property, the 45-Day Rule and 180-Day Rule still apply.
1031 Exchange Debt Rules & How Debt Works
Investors need to know that the debt used to finance the exchanged property must be dealt with properly to avoid a tax bill. IRS regulations stipulate that any liabilities the investor is relieved of as a result of the transaction are considered money received. This means that when the investor sells the exchanged property and mortgage debt is paid off with sale proceeds, the IRS could view this as a taxable gain to the investor.
Debt Replacement in 1031 Exchanges
To avoid being stuck with capital gains taxes or a “boot”, investors must replace the amount of debt on the exchanged property with the amount of debt on the replacement property. This is done by applying an equal or greater amount of debt to the replacement property, or if the investor uses cash not obtained from the exchange transaction to replace the debt.
Reinvestment Requirements
As discussed above, the “boot” refers to the capital gains taxes associated with a failure to replace an equal or greater amount of debt on the new replacement property. Investors can utilize four reinvestment methods to avoid the “boot,” traditional financing, cash on hand (not associated with the transaction), private lenders, or seller financing. These avenues pave the way to keeping the transaction capital gains free, which is the motivating factor for most investors engaging in a 1031 Exchange.
Can an Investor Pay Debt with a 1031 Exchange?
Exchange funds can only be used to pay off debts that are secured by a mortgage or deed of trust. Therefore, exchange funds cannot be used to pay off other debts like an auto loan. It is also important to consider that if an investor used unsecured funds to originally finance the exchange property, then the exchange proceeds cannot be used to pay off this debt.
Debt, 1031 Exchanges, & Private Equity Real Estate
Utilizing a 1031 Exchange in any real estate investment scenario requires high attention to detail and a comprehensive understanding of the rules related to debt. These rules can be difficult to navigate, and the embedded time constraints can complicate the exchange process For investors wishing to have their real estate assets managed by someone else, investing with a private equity firm allows the investor to benefit from the experience and track record of the management team.
Updates to 1031 Exchanges for 2023
Given the rising popularity of 1031 Exchanges as a way to defer taxes upon the sale of an appreciated property, there have been discussions over the years to alter the rules related to 1031 Exchanges. In fact, 1031 Exchange limitations were previously proposed by the Biden Administration but did not move forward. For now, this tax deferral benefit is available to investors who meet the criteria described in this article.
How to Execute a 1031 Exchange
Executing a 1031, tax-deferred Exchange begins with identifying a property an investor wishes to sell. Next, an investor must identify a property they would like to buy and choose a qualified intermediary. Once the process begins, the investor must determine if they would like to use all or some of the proceeds for the replacement property, keeping in mind that any proceeds not used for reinvestment will be subject to taxation. Furthermore, the investor will need to keep an eye on the calendar to avoid breaking the 45-Day or 180-Day Rule. Lastly, the investor will need to file IRS Form 8824 with their tax return.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.oceeds into another “like kind” property. This transaction is known as a “1031 Exchange,” but it can also be referred to as a “like-kind exchange” or “starker exchange.”
In this article, we’ll discus what a 1031 exchange is, key terms you need to know, and 1031 exchange rules.
What is a 1031 Exchange?
A 1031 Exchange is a specialized type of real estate transaction that allows investors to defer taxes on the profitable sale of an investment property. The rules that sanction this transaction type of transaction are outlined in section 1031 of the Internal Revenue Code (IRC), which state specifically that “…no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind…”
There are three obvious benefits to a 1031 Exchange:
- Increased Purchasing Power: By deferring taxes, an individual can use the money that he or she would have paid in capital gains taxes to afford a larger property with greater value. Typically, this also means more cash flow, which creates a positive cycle that is favorable for portfolio growth.
- Diversification: 1031 Exchange properties do not have to be one-for-one. As such, they can be an effective tool to diversify an investor’s real estate portfolio in a one-for-many exchange. For example, one property with a large gain could be exchanged into three different property types and locations.
Specifically, §1031(k)-1(c)(4) states that the “maximum number of replacement properties that a taxpayer may identify” is either: (A) three—without regard to their fair market value; or (B) any number of properties, as long as their aggregate fair market value as of the end of the identification period does not exceed 200% of the aggregate fair market value of all of the relinquished properties.
- Upgrades: If a property is in need of major renovations or repairs, a 1031 Exchange can be an easy and cost effective way to upgrade a physically obsolete asset (or one where the cost basis has been depreciated to zero). By exchanging an older property for a newer one, an individual has effectively upgraded the investment for little to no additional cost.
The biggest risk to a 1031 Exchange is that the rules may not be closely followed, causing the gain to become taxable. In order to avoid this situation, it is important that individuals understand the major requirements. But, first, it is necessary to understand the key terms used to define the requirements.
1031 Exchanges – Key Terms
There are a handful of key terms that must be understood in order to interpret the 1031 Exchange requirements, as defined by the Internal Revenue Service (IRS). They are defined below:
- Relinquished Property: The property being sold. Sometimes called the “old property” or the “original property.”
- Replacement Property: The property being purchased. Sometimes referred to as the “new property.”
- Qualified Intermediary: An individual or firm who is an expert in 1031 Exchange rules. They act as an exchange facilitator on behalf of the exchanger and handle the money to ensure the transaction is in full compliance with the rules.
- Gain: The difference between a property’s cost basis and the sales price.
- Boot: Money or fair market value of “other property” received in a 1031 Exchange. It is taxable.
These are the basic terms that allow for a full understanding of the rules of a 1031 Exchange.
1031 Exchange Rules – What You Need to Know
The key to executing this type of transaction correctly is to follow the 1031 exchange rules. In most transactions, the Qualified Intermediary (QI) is there to ensure that the following 1031 exchange requirements are met:
- Time Limits: In a deferred exchange, investors have 45 days from the sale of the Relinquished Property to identify potential replacement properties. In addition, they have 180 days from the sale of the Relinquished Property to close on the Replacement Property or properties.
- Like Kind Test: The Replacement Property must be “like kind” to the Relinquished Property. The “like kind” definition is broad, but it generally refers to the “nature or character of the property while ignoring differences of grade or quality.” It should be noted that the rules do not make a distinction between property types. For example, it is possible to exchange an office building for an apartment building.
- Held for Sale: The property cannot be “held for sale.” This means that an investor cannot complete the exchange for the tax deferral benefits and then immediately sell the Replacement Property. Although there is no specific timeline defined in the rules, it is generally agreed that a Replacement Property should be held for 12-24 months.
- Value: The market value and equity of the Replacement Property must be the same as or greater than the Relinquished Property. For example, if the Relinquished Property has a value of $5M and a mortgage balance of $3M, the Replacement Property must have a value of at least $5M and debt of at least $3M.
- No Boot: Again, “boot” is cash or the fair market value of any “other property” received in the transaction. If it is received, it is taxable. For example, if the mortgage on the Relinquished Property was $2M and the mortgage on the Replacement Property is $1.8M, the $200k difference is “boot” and it can be taxable.
- Taxpayer: The Replacement Property and the Relinquished Property must be titled similarly.
- Excluded Property Types: There are a number of property types that do not qualify for deferral under a 1031 Exchange, including: primary residences, rental properties, secondary homes, or vacation homes. In addition, inventory, stocks, bonds, notes, partnership interests, and certificates of trust do not qualify.
If any of the above 1031 exchange rules are not followed, the tax deferral benefits may be nullified, and all or some portion of the gain could become taxable. In order to prevent this, it is a best practice to work with well-regarded Qualified Intermediary along with knowledgeable real estate attorneys and tax accountants.
How to Execute a 1031 Exchange
You must exchange one property for another property of the same or greater value. It must be like-kind (ex: real estate for real estate). This is a huge tool for real estate investors and the tax reformers in Washington would like to see it removed.
What are the 1031 Exchange loan rules? The 1031 exchange rules require that both the purchase price and the new loan amount be the same or higher on the replacement property. If an investor were selling a $5 million property in New York that had a $2 million dollar loan, they would have to buy $5 million or more of replacement property with $2 million or more in debt attached to the purchase.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our real estate investing opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
