What is a 1031 Tax Deferred Exchange?

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind" while deferring the payment of federal income taxes and some state taxes on the transaction. The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement

Types of IRC 1031 Exchanges

1.      Delayed Exchange: This is the most common type of exchange. A Delayed Exchange occurs when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. A Delayed Exchange is subject to strict time restrictions outlined in the Treasury Regulations.

2.      Reverse Exchange is when the replacement property is acquired before transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000.

3.      Build-to-Suit (Improvement or Construction) Exchange: This technique allows you to use the exchange proceeds to build on or improve the replacement property.

4.      Simultaneous Exchange: The exchange of the relinquished property for the replacement property occurs simultaneously.

Benefits of 1031 Exchange

·         Defers capital gains taxes
A 1031 exchange exempts a real estate transaction from capital gains tax.
Depending on the state of residence, this can be a 20 to 30 percent savings on tax from the sale. For businesses or individuals who trade in investment properties, avoiding the capital gains tax is crucial to remaining profitable.

·         More buying power:
Performing a 1031 exchange instead of a straight sale allows the Exchanger to purchase new property of equal value instead of being limited to 70 to 80 percent of the proceeds after taxes are withheld.

·         Defers payment of depreciation recapture

·         The heir receives the property with a step-up in basis:
If Exchanger dies owning the property, Exchanger's heirs get a step up in basis.
Upon the death of the original seller, any deferred capital gains taxes from 1031 exchanges are erased. The properties purchased using the exchange are then passed on to the seller's heirs without the deferred taxes.

Additionally, the heir receives the property on a step-up basis. This statement means the property is inherited with a cost basis matching its current market value, not the value at which the original seller purchased the property.

For example, say that a property is originally purchased for $400,000. Years later, the property has a fair market value of $700,000. The seller dies and passes it along to an heir.

The heir inherits that property with a cost basis of $700,000, not the original $400,000.

If the heir sells the property immediately at fair market value, they would not need to pay capital gain taxes since there is no difference between the cost basis and the property's sale price. If the heir waits a few years and sells the property valued at $1 million, they would have to pay capital gains taxes on the $300,000 difference between the cost basis and the sale price.

Alternatively, the heir can perform a 1031 exchange and defer capital gains taxes, restarting the process.

DISADVANTAGES of 1031 Exchange

While the benefits of 1031 exchanges are attractive for investors, there are some disadvantages to consider before deciding to move forward with a 1031 exchange. A 1031 exchange won’t work for all investment property owners. Some drawbacks to consider include:

·         Cost of Failure

If a seller cannot meet the deadlines for the 45-day identification period or the 180-day exchange period, the 1031 exchange is considered a failure. Therefore, the seller will not be able to defer the capital gains tax from selling their property.

·         Upon a 1031 exchange failure, sellers have to pay the capital gains taxes for their recent sale and any sale they have performed in the past that utilized the 1031 exchange rule.

·         Upon a 1031 exchange failure, The seller loses all other expenses incurred related to this 1031 Exchange, such as payment to the Qualified Intermediary (QI)

·         Recapture Depreciation Expenses:
Capital gains taxes are calculated based on a property’s original purchase price plus improvements and minus depreciation. Depreciation is the cost of an investment property written off yearly due to wear and tear. If an investor sells a property for more than its depreciated value, they have to recapture that depreciation as part of their taxable income from selling the property.

·         Disqualification from a 1031 exchange for “flipping.”
Most real estate investors who own exchange properties used for investment or business purposes, such as renting, should hold their properties for a minimum of two years to prove the intent of use to the IRS and avoid being disqualified from a 1031 exchange for “flipping.”

Rules, Restrictions, and REQUIREMENTS OF THE 1031 EXCHANGE

Qualifying Real Estate Property for a 1031 Exchange:

1031 exchanges only apply to commercial or investment properties, within the United State, not personal residences.

Real estate property held for business use or investment qualifies for 1031 Exchange. A personal residence does not qualify; generally, a fix-and-flip property also doesn't qualify because it fits in the category of property being held for sale. Vacation or second homes, which are not held as rentals, do not qualify for 1031 treatment; however, a usage test under Paragraph 280 of the tax code may apply to those properties. A tax expert should be consulted In this case.

Land under development and property purchased for resale do not qualify for tax-deferred treatment. Stocks, bonds, notes, inventory property, and beneficial interest in a partnership are not considered "like-kind" property for exchange purposes.

To qualify as a 1031 exchange today, the transaction must be an "exchange" rather than just a sale of one property with the subsequent purchase of another. First, the sold property and the new replacement property must be held for investment purposes or productive use in a trade or a business. They must be "like-kind" properties.

Like-Kind Requirements:
The exchanged property (Relinquished Property, RQ) and the newly acquired property (Replacement Property, RP) must be a qualifying type of real estate, such as an apartment building or office complex. 1031 exchanges are often called "like-kind" exchanges because of this requirement.

The term "like-kind" in the tax code merely means that the taxpayer cannot use proceeds from the sale of an asset in a specific asset class to purchase a new asset in a different asset class. In short, real estate for real estate, livestock for livestock, or rare gems for rare gems meets the definition.

Qualified like-kind "real property":
The following list items are like-kind with each other.

·         Oil & Gas Mineral Rights

·         Bare Land

·         Single-Family

·         Multi-Family

·         Commercial/Office/Retail

·         Vacation Rentals – non-personal use

·         DSTs (Delaware Statutory Trust)

Non-Qualified Like-Kind "real property" Examples:

·         Primary Residence

·         Second Homes or Vacation Properties – personal use

·         Inventory Property

·         Flips. There could be a minimum period to wait or defer, e.g., two (2) years or more. *(1)

·         Develop then Sell. There could be a minimum period to wait or defer, e.g., two (2) years or more. *(1)

·         Interest in a Partnership

·         Personal Property

·         Cars

·         Art

·         Planes, etc.

Some examples of exchanges that can be performed under the 1031 Exchange rules include:

·         A multifamily property for an industrial building.

·         Vacant land for a medical complex.

·         An apartment building for a shopping center.

·         A hotel for a retail property.

·         A condominium rental for a single-family rental.

Some examples of exchanges that cannot be performed under the 1031 Exchange rules include:

·         Exchanging primary residences that have not been converted into rental properties.

·         Exchanging a primary residence for a business property of any type. *(1)

·         Exchanging a property that is held primarily for sale, including property held by a flipper or stocks, bonds, or notes

·         Exchanging real estate property for personal property, including artwork, aircraft, or boats.

·         Exchanging a property in the U.S. for property in a foreign nation.

(*1): Currently, on 1031 exchanges, taxpayers must have used a residence as a rental property with tenants before selling it through a 1031 exchange. Although there is no set-in-stone timeframe, typically, a residence is recommended to have been used for at least 24 months as a rental property before it can qualify for a 1031 exchange. This amount of time should show the IRS that the intent of the property was for productive use.

For the latest rules and restrictions on this issue, contact your CPA or a Tax expert.

Time Frame

Strict time limits must be followed for a transaction to qualify as a 1031 exchange. After selling the property, the Exchanger has 45 days to identify replacement property/properties. The Exchanger then has 180 days from the date of sale to purchase the identified property/properties. These timeframes cannot be extended, even when the deadline falls on a weekend or government holiday.

Debt Requirements

The new property must be encumbered by at least the same amount of debt as the exchanged property. Suppose the debt on the new property is lower than the proceeds from the sale of the RQ property. The transaction will be considered a partial 1031 exchange, and the Exchanger will be subject to capital gains tax on the difference which is called BOOT.

Boot: Anything the Taxpayer receives, including cash at closing, that is not “like-kind” (aka, taxable)

Must Use a Qualified Intermediaries (QI)

A 1031 exchange is invalid if the Exchanger handles the proceeds from the sale at any point in the process. Even if the money is only temporarily in the Exchanger's possession while the new property is being acquired, it is considered a constructive receipt, and the Exchanger will be taxed on the gain from the sale.

To facilitate a proper 1031 exchange, a must be used. The QI must be an independent third party not affiliated with you, your attorney, CPA, or other agents. The QI holds the proceeds from the sale and disburses money when it is time to purchase the new property.

What Qualifies for Full Tax Deferral "exchange up" 1031 exchange?

·         Apply only to commercial or investment real properties.

·         Buy the equal or greater value of the qualified like-kind "real property."

·         Get/contribute equal or greater debt/cash.

·         Use all the sales proceeds.

Example:

Steps of the 1031 exchange

1.      Hire a Qualified 1031 Exchange Intermediaries (QI) as soon as you sold the investment property

2.      The QI opens the escrow account and works with the title company

3.      At closing, the title company sends two wires

4.      Send the client critical info and a statement of funds letter

5.      Receive a 45-day ID letter from the client

6.      To purchase a Replacement Property, send the contract to QI

7.      QI works with the title company and wire funds at closing

8.       Close the exchange

Some Questions and Answers:

Assume you own a fourplex, live in one of the units, and have rented the other three units for the last three years.
Q1: Can you use 1031 Exchange to sell your four-plex and purchase an existing shopping center?
A1: Yes, but only ¾ of the proceeds, the investment portion, can be used in 1031 Exchange, and you are responsible for the capital gain of the other 1/4^th of proceedings.

Assume you own a rental house, and you are renting it for the last three years.
Q2: Can you use 1031 Exchange to sell your rental house and purchase a newer rental duplex?
A2: Yes, but you cannot live in any of its unit for the minimum period dictated by the IRS, which is two years, but check with your CPA for the latest update. This minimum period requirement is known as waiting time or deferred time.

Assume you own a lot
Q3: Can you use 1031 Exchange to sell your lot to build a new house somewhere else?
A3: Yes, but you must meet the following two requirements.

1.       You must complete the construction of the new build within 180 days of the sale of your lot,  AND

2.       You cannot live in any of its units for the minimum period dictated by the IRS, which is two years, but check with your CPA for the latest update. This minimum period requirement is known as waiting time or deferred time.