Part of the requirement for completing a 1031 Exchange is that once real estate investors sell their property, they are required to find a “replacement property” within 45 days. While this may seem simple enough, it can actually turn out to be very challenging for investors to find just the right property in a relatively short period of time.
In this article, we are going to discuss the exchange rules that investors need to be aware of when planning on purchasing a replacement property to complete a 1031 Exchange. We’ll start by describing 1031 Exchanges in general and then discuss the rules and specifics of replacement properties. By the end, readers will have a better idea of what to be aware of when shopping for a replacement property as part of a 1031 exchange.
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What is a 1031 Exchange?
Before discussing the ins and outs of replacement properties, it first makes sense to define what a 1031 exchange is more broadly.
A 1031 exchange is a type of commercial real estate transaction that allows taxpayers to defer capital gains taxes on the profitable sale of an investment property (the “relinquished property”) as long as they reinvest the sales proceeds into a new property (the “replacement property”). A 1031 exchange is also known as a like-kind exchange because the replacement property must be “like kind” to the property that was sold. In addition to this requirement, there are a few rules set forth by the IRS that investors must follow:
- Investors must identify their potential replacement properties within 45 days of the sale of the relinquished property and close on the purchase of the replacement within 180 days.
- The equity and the debt in the replacement property must be equal to or greater than the equity and debt in the relinquished property.
- Both the relinquished property and the replacement property must be titled similarly – usually a limited liability company (LLC).
- The replacement property must be a like kind property to the one that was sold – meaning they must be of the same nature or character. In general, most commercial properties are like kind to other commercial properties.
- Both properties (the relinquished and replacement) must be held for use in a trade or business or for investment purposes. Property with a personal use, like a primary residence or vacation home, does not qualify for like-kind exchange treatment.
When the 1031 exchange process is completed within the bounds of internal revenue code (IRC) exchange rules and the related timeframe, investors are able to use the exchange as a way to enjoy an indefinite capital gains tax deferral on the profit.
Does an exchange of Relinquished Property for Replacement Property Have to Be One-for-One?
One of the biggest perks about a 1031 exchange, in addition to the tax benefit, is the possibility for investors to diversify their portfolios through the exchange. Investors looking to increase the number of properties held in their investment portfolio can exchange one property for multiple properties as long as the following rules are met (in addition to the others listed above related to time limits, etc.):
- Three Property Rule: The exchanger can identify up to 3 like kind replacement properties.
- 200% Rule: The exchanger can identify unlimited properties as long as the total value of the property does not exceed 200% of the market value of the relinquished asset (original property).
- 95% Rule: The exchanger can identify more than three properties whose value exceeds 200% so long as they acquire 95% of the value of the replacement properties.
These rules open up numerous possibilities for investors. A property owner who has a significant portion of her net worth invested in a single office building or large apartment building can use a 1031 exchange to select multiple replacement properties. Using this strategy, the investor would be able to sell the single, large holding and replace it with multiple properties as long as the sales price of the replacement property meets these rules.
“Equal or Greater” on a Replacement Property
One of the most important things to know about a 1031 exchange is that the fair market value, or purchase price, of the replacement property must be of equal or greater value than the relinquished property. Additionally, the investor must reinvest all the equity proceeds from the sale of the relinquished property in order to get the full tax deferral. An example will help to illustrate how this works.
Let’s suppose that a married couple owns a rental property for which they paid $1MM and are going to sell for $2MM. For the sake of this example, assume that the property has a $500,000 loan against it at the time of sale, which means that the net proceeds at the time of sale are $1.5MM.
To get the full tax deferral, the investors must reinvest at least $1.5MM into the replacement property. The debt of $500,000 can be handled in two ways. Either the investors can take a loan of at least $500,000 to buy the replacement property, or they can contribute additional cash of at least $500,000 to avoid a tax liability.
If a Replacement Property’s Value Isn’t Equal or Greater
When an investor negotiates a sale price with the seller of the replacement property that is less than the value of the relinquished property, the investor may be on the hook for a capital gains tax liability. Similarly, when the investor does not replace the debt on the relinquished property with at least as much debt on the replacement property, or by bringing more cash to the deal, then a tax liability will be created.
As it relates to 1031 exchanges, the difference between the fair market value of the relinquished and replacement properties is known as “boot”. Boot is an amount of money that is considered taxable as part of the transaction. When a 1031 exchange results in boot, it is said to be a partial exchange. Let’s discuss partial 1031 exchanges in more detail.
A Brief Rundown of Partial 1031 Exchanges
In order to obtain complete tax deferral, investors must comply with the rules listed above (in addition to others) when completing a 1031 Exchange. One of the most important rules is that real estate investors must reinvest all of their sales proceeds into the new property. If they don’t, the portion not invested is known as “boot”, and that part of the gain is taxable. Let’s use our example from earlier to understand how boot is created.
Our married couple from earlier owns a rental property for which they paid $1MM and are going to sell for $2MM. For the sake of this example, assume that the property has a $500,000 loan against it at the time of sale, which means that the net proceeds at the time of sale are $1.5MM. There are two potential ways to create a partial 1031 Exchange out of this scenario.
The first is to buy a replacement property that is less expensive than the net proceeds obtained. For example, suppose that replacement investment property can be purchased for $1.3MM. The $200,000 difference is considered to be “cash boot”, and this portion of the transaction is taxable.
The other scenario that creates boot has to do with debt. Suppose that the couple purchases a replacement 1031 Exchange property for $3MM, but takes on $2MM in debt. The $1MM in equity on this deal is less than the $1.5MM in net sale proceeds. The $500,000 difference is taxable.
1031 Exchange rules state that any difference between the amount of net sales proceeds received and total amount invested in the replacement property is considered to be a partial 1031 Exchange. Any difference between net sales proceeds and those invested in the new property is considered to be “boot” and is taxable.
Summary of 1031 Exchanges & Replacement Property Value
IRS 1031 Exchange rules specifically state that like kind replacement properties must be “of the same nature, character, or class” as the relinquished property. The quality or grade of the properties does not matter, and it can involve investment property or business property, but not personal property. Most real estate is like kind to other real estate as long as both properties are located within the United States. For example, an office building could be considered like kind to a shopping center.
In addition to meeting the relevant exchange timelines, investors must be aware of several rules related to replacement property in order to avoid having to report a capital gain on their income tax return. It’s also important for investors to know that they can use 1031 exchanges to swap one property for multiple pieces of real property.
Completing a tax-deferred exchange can be complex and the consequences of not following the rules can be costly, so it is a best practice for individual investors to work with an expert to complete the exchange process. These experts could include a qualified intermediary, real estate broker, real estate agent, tax advisor, attorney, CPA, or private equity firm like ours. They will be able to help investors understand if a 1031 exchange is right for them and which type of exchange is relevant to their situation. These advisors will be able to help investors decide among the different 1031 exchange options, including partial exchange, simultaneous exchange, delayed exchange, or reverse exchange.
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