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 proceeds 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.
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.
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