What is a 1031 Exchange?
A 1031 Exchange is a specialized real estate transaction that allows investors to defer capital gains taxes on the sale of an investment property. By utilizing a 1031 Exchange, investors can defer capital gains that would otherwise be due upon the sale, provided they reinvest the proceeds into another qualifying property. The rules authorizing this type of exchange are found in Section 1031 of the Internal Revenue Code (IRC), which states 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…”
The 3 Primary Benefits to a 1031 Exchange:
- Increased Purchasing Power: By deferring taxes, investors can apply the capital that would have gone toward taxes to purchase a larger or higher-quality property. This often translates into stronger cash flow and greater portfolio growth over time.
- Diversification: 1031 Exchange properties do not have to be one-for-one. They can facilitate diversification through a one-for-many exchange. For instance, one property with a large gain can be exchanged for three properties in different markets and sectors. Specifically, §1031(k)-1(c)(4) provides that the “maximum number of replacement properties that a taxpayer may identify” is either: (A) three, regardless of fair market value; or (B) any number of properties, as long as their total fair market value as of the end of the identification period does not exceed 200% of the aggregate fair market value of the relinquished properties.
- Upgrades: A 1031 Exchange can also be an effective way to replace an aging or fully depreciated property with a newer, higher-quality asset. By exchanging rather than selling outright, an investor can upgrade the portfolio with little to no additional cost.
The greatest risk in a 1031 Exchange is failing to follow the rules precisely, which can trigger a taxable event. To avoid this, investors must understand the key requirements and definitions.
1031 Exchanges – Key Terms
To navigate 1031 Exchange requirements properly, investors should understand the following IRS-defined terms:
- Relinquished Property: The property being sold, also referred to as the “old property” or “original property.” It is important to clearly define ownership interests, including ownership percentages and the legal structure of ownership, when identifying Relinquished Property for an exchange.
- Replacement Property: The property being purchased, also known as the “new property.” Replacement Properties are typically held as investments for profit and must meet IRS requirements for like-kind exchanges.
- Qualified Intermediary: A third-party expert who facilitates the exchange, holds proceeds, and ensures compliance with IRS regulations.
- Gain: The difference between a property’s cost basis and its sales price. Gain represents the profit realized from the sale of the property.
- Boot: Money or the fair market value of “other property” received in a 1031 Exchange. It is taxable.
These definitions form the foundation for understanding 1031 Exchange rules.
1031 Exchange Rules & Guidelines: What You Need to Know
1031 Exchanges are complex real estate transactions governed by strict IRS regulations, including two key timing rules that dictate the identification and acquisition periods. Adherence to these rules is essential for successful transactions and achieving tax deferral. To ensure a valid exchange, investors must comply with each rule.
Like-Kind Properties Rule
The like-kind rule allows exchanges of properties used for business or investment purposes, even if they are in different asset classes. For example, an apartment building may be exchanged for an industrial warehouse, commercial property, rental property, or even raw land, as long as both are considered like kind property and are held for investment or business use.
Exclusions include primary residences, foreign-to-domestic exchanges, and the exchange of physical property for financial assets such as stocks or bonds.
Three-Property Rule
The Three-Property Rule permits investors to identify up to three potential properties to purchase, provided they close on at least one. In the property identification process, investors can list up to three identified properties, which serve as potential Replacement Properties and backup options in case the primary choice falls through. The 200% Rule and 95% Rule are exceptions.
An investor may invoke the Three-Property Rule to diversify their portfolio or navigate certain 1031 Exchange limitations.
200% Rule
As an exception to the Three-Property Rule, the 200% Rule allows an investor to identify multiple properties as identified Replacement Properties, provided their combined fair market value does not exceed 200% of the Relinquished Property’s valued amount. For example, an investor selling a property for $1 million could identify four potential Replacement Properties or more, as long as the total value of all identified Replacement Properties does not exceed $2 million. These properties must be accurately valued at the time of identification to ensure compliance with IRS rules. Some investment vehicles, such as Delaware Statutory Trusts (DSTs), may have a minimum investment requirement, which enables investors to diversify by spreading funds across multiple properties. To fully comply with the 200% Rule, the identified Replacement Properties must be acquired within the required exchange timeframe.
95% Rule
Under the 95% Rule, an investor can identify any number of Replacement Properties, regardless of total value, as long as they acquire at least 95% of the aggregate value of the identified properties.
For example, selling a $2 million property and identifying 20 Replacement Properties worth $10 million would still qualify if the investor acquires $9.5 million or more of the value of those identified properties.
This rule is often used by investors seeking to identify a large pool of potential assets while committing to close on nearly all of the identified properties.
45-Day Time Limit
Investors have 45 calendar days from the sale of the Relinquished Property for identifying Replacement Properties, using valid identification methods such as the Three-Property Rule, the 200% Rule, or the 95% Rule. This period includes weekends and holidays.
180-Day Deadline
From the date the Relinquished Property is sold, investors have 180 days to complete the purchase of the Replacement Property or properties. In effect, investors have 45 days to identify and an additional 135 days to close.
How to Formally Identify (Written Notice & QI)
Within the 45-day identification window, investors must identify Replacement Property in writing. The property must be “unambiguously” described, typically by legal description, address, or a distinct name.
This written notice must be delivered by midnight on the 45th day to a party involved in the exchange who is not a disqualified person. Working with a Qualified Intermediary helps ensure this step, and the entire exchange, remains compliant.
Incidental Property Rule
Sometimes, Replacement Property includes incidental personal property (e.g., furniture or fixtures). Under the incidental property rule, such items are considered separate and do not qualify for tax deferral, even though they do not disqualify the exchange itself.
What is Not Allowed in a 1031 Exchange
Once a sale has closed, it is too late to initiate a 1031 Exchange. Additionally, primary residences and foreign-to-domestic exchanges are not permitted.
Types of 1031 Exchanges
There are four primary types of 1031 Exchanges: two-party simultaneous exchanges, delayed exchanges, reverse exchanges, and construction-related exchanges.
- Two-Party Simultaneous Exchange This original form of 1031 Exchange involves two owners swapping deeds simultaneously. In practice, it is rare today because it is difficult to align fair market values and financing structures between parties.
- Delayed Exchange The most common structure, a Delayed Exchange involves selling the Relinquished Property first, followed by the purchase of a Replacement Property within the 45/180-day timeline.
- Reverse Exchange In a reverse exchange, the investor acquires the Replacement Property before selling the Relinquished Property. Because investors cannot hold both simultaneously, an Exchange Accommodation Titleholder (EAT) temporarily holds one property via a special purpose entity, often an LLC.
- Construction or Improvement Related Exchanges This variation allows investors to use exchange funds to improve a Replacement Property. However, both the 45-Day and 180-Day Rules still apply.
1031 Exchange Debt Rules & How Debt Works
Debt associated with the exchanged property must be carefully managed to prevent triggering taxable gain. When a property is sold and its debt is paid off, the IRS may consider the discharged debt as income unless it is properly replaced.
Debt Replacement in 1031 Exchanges
To avoid recognizing gain or “boot,” the debt on the Replacement Property must be equal to or greater than the debt on the Relinquished Property. Investors may replace debt with either new financing or cash not derived from the exchange proceeds.
Reinvestment Requirements
As noted, “boot” results when the investor fails to replace the full debt amount. This can be avoided by using one of four reinvestment methods: traditional financing, personal cash, private lending, or seller financing.
Can an Investor Pay Debt with a 1031 Exchange?
Exchange funds can only be used to pay off debts secured by a mortgage or deed of trust. They cannot be used for unrelated debts such as car loans or unsecured obligations.
Debt, 1031 Exchanges, & Private Equity Real Estate
The interplay between debt and 1031 Exchange rules requires precision. For investors seeking a more passive approach, working with a private equity real estate firm offers professional management while maintaining compliance and strategic execution.
Updates to 1031 Exchanges for 2023
Despite periodic discussions about limiting or eliminating 1031 Exchanges, most recently under the Biden Administration, no changes have been enacted. For now, the 1031 Exchange remains a valuable tax-deferral strategy for qualified investors.
How to Execute a 1031 Exchange
Executing a 1031 tax-deferred exchange begins with selecting a property to sell and identifying a potential exchange property as the replacement. Investors must then select a Qualified Intermediary and determine how much of the sale proceeds will be reinvested. Any portion not reinvested will be subject to taxation. Timely adherence to the 45-Day and 180-Day Rules is essential, as failure to meet these deadlines can result in immediate capital gains tax liability. The transaction must be reported to the IRS via Form 8824.
Example: If an investor sells a $5 million property in New York with a $2 million loan, the exchange property must be purchased for at least $5 million with debt of $2 million or more to satisfy the 1031 Exchange loan rules.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With a disciplined focus on acquiring world-class, multi-tenant assets below intrinsic value, we aim to deliver superior, risk-adjusted returns for investors while strengthening the communities we invest in.
To learn more about our current real estate opportunities, contact us at (800) 605-4966 or ir@fnrpusa.com
