1031 Tax-Deferred Exchanges...
   Everything you need to know!

 

What is a Tax Deferred Exchange?

A tax deferred exchange is simply a method by which a property owner trades one property for another without having to pay any federal income taxes on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. But in an exchange, the tax on the transaction is deferred until some time in the future, usually when the newly acquired property is sold

These exchanges are sometimes called "tax free exchanges" because the exchange transaction itself is not taxed.

Tax deferred exchanges are authorized by Section 1031 of the Internal Revenue Code. The requirement of Section 1031 and other sections must be carefully met, but when an exchange is done properly, the tax on the transaction may be deferred. 

In an exchange, a property owner simply disposes of one property and acquires another property, rather than the sale of one property and the purchase of another. 

Today, a sale and a reinvestment in a replacement property are converted into an exchange by means of an exchange agreement and the services of a qualified intermediary - a fourth party who helps to ensure that the exchange is structured properly. 

The IRS' new regulations make exchanging easy, inexpensive and safe.

Internal Revenue Code (IRC) Section 1031 is one of the last remaining tax loopholes. It is a powerful tool that allows investors to exchange any investment property for any other investment property. For your exchange to be valid, you must follow specific IRS regulations. 

Here is an abbreviated list of the regulations.

1.) The properties being exchanged must be of a like kind. For example, you may exchange: 

• a house for another house (or several houses)
• a house for commercial real estate
• land for rental property
• a strip mall for an office building
• any investment property for any other investment property (as long as it is not occupied as your primary residence)

2.) You must identify and close on your replacement property within a specific period of time.

• You must identify the property (can identify 3 of them) within 45 days of selling your other home (day of settlement)
• you may not use ANY of the proceeds from the sold property or you will negate the exchange - not one penny
• You must settle on one of the three identified properties within 180 days from day of settlement (do not count this by months as some months have 31 days)

3.) 100% of the proceeds from your current property must be held by a Qualified Intermediary and applied toward your replacement property to get a full tax deferral.

4.) Your replacement property must be of equal or greater value to the property you have sold to get a full tax deferral.

5.) Properties being exchanged must be used for investment. Personal residences are not exchangeable.

Why use a 1031 exchange:

To defer your capital gains tax

To diversify

• Exchange one property for a larger one.
• Exchange one property for several properties.
• Increase depreciation.

To simplify

• Exchange several properties for fewer (or one) property.
• Improve the quality of your property.
• Decrease management responsibility.

To relocate

• Exchange for a property closer to where you live.
• Exchange to an area with higher appreciation.

Please consult your tax advisor

 

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Frequently Asked Questions

What is a tax deferred exchange?
When the proceeds from the sale of investment real estate are used to purchase other Like-Kind investment real estate, you should consider a tax deferred exchange. The use of an Accommodator or Qualified Intermediary throughout your transaction is recognized as a Safe Harbor under IRS Regulations.

How can I qualify to pay NO taxes when I sell my property?
Any investor can qualify! Section 1031 of the IRS code lets you sell your property and buy a new property without paying any taxes. You simply follow specific rules.

What is a qualified intermediary?
The IRS says if you touch the money you pay the tax. However, if you use a qualified intermediary (or accommodator or facilitator) to transfer the money from the sold property into the purchased property, you qualify for a tax free exchange. The IRS does not permit your accountant, attorney, or escrow company to be your qualified intermediary.

Can I get legal or tax advice from a qualified intermediary?
No, the IRS doesn't allow a qualified intermediary to give legal or tax advice. However, they will work with your attorney and CPA to make sure your tax free exchange goes smoothly.

Can I avoid paying taxes forever?
Yes, you can. By simply following the 1031 exchange rules every time you sell one or more properties and buy replacement properties, when you die your estate escapes all the capital gains taxes forever!

What exactly are the tax advantages in exchanging?
You can eliminate paying any capital gains taxes, and you can eliminate paying the even higher-rate taxes on the recapture of depreciation you've taken on your property. By exchanging into a higher priced property you'll also gain additional depreciation deductions which can increase your after-tax income.

Are there reasons to exchange other than tax advantages?
Yes, there are many non-tax reasons to exchange. For example, if you no longer like managing property, you can exchange your management intensive property for triple-net management free property, or exchange multiple smaller properties for one that can be professionally managed. Or, say your current property cannot be easily refinanced. You could exchange out of that property for a new property which could be refinanced more easily so you can take some cash out. Or, you might exchange to improve cash flow.

What kind of real estate qualifies for a 1031 exchange?
Almost every kind of real estate is considered "like kind" and can be exchanged for any other real estate, including vacant land for apartments, a rental house for a shopping center, an office building for a leasehold interest with 30 years or more remaining, as long as you hold them for investment or business use.

How long can I take to buy a new property?
To do a Delayed Exchange you need to keep in mind that there are two very important time restrictions: the 45 day identification period and the 180 day exchange period. These time restrictions are strictly enforced. There are neither exceptions nor extensions. Once you have violated one of these time periods, your whole exchange fails. You have 180 days between the closing date on the sold property and the closing date on the purchased property. Do not think that this is 6 months  - COUNT THE DAYS ONLY

If the exchangor’s 45th or 180th day falls on a weekend or holiday do I get the benefit of the following business day?No. The IRS calculates this timeline based on calendar days. There are no extensions given.

Can I buy a new property before selling my old one?
Yes, you can buy a new property before selling the old property and still qualify - it's called a "reverse" exchange. The qualified intermediary takes title to the new property you buy and holds it for you until you sell your old property.

What are the requirements for deferring tax on a capital gain?
In order to defer all of the tax on the sale of investment property, first make sure that the relinquished and replacement properties are “like kind” and held for productive use in a trade or business or for investment. Second, make sure that the timelines for the exchange are met. Third, make sure that all of the proceeds generated by the sale of the relinquished property are used in the purchase of the replacement property and that the FMV (fair market value) of the replacement property is equal to or greater than sale price of the relinquished property. If any of the first two requirements listed are not met, no exchange is possible. If any of the third requirement is not met, a taxpayer may be able to partially defer their gain but not wholly.

Can I use my IRA in conjunction with a 1031 Exchange?
Yes, if you do it right.

Using an IRA for real estate requires a special Self-Directed IRA. Your Self-Directed IRA at Charles Schwab or Fidelity does NOT permit you to hold real estate or any asset other than securities. This can be solved by moving your IRA to a custodian that allows for real estate in the plan document. With the right Self-Directed IRA (known as Real Estate IRA) and proper structuring, you partner with your IRA to buy leveraged real estate. When it comes time to sell, you can 1031 your portion of the gain while the IRA gets its portion of the gains tax exempt.

Can I buy more than one piece of property tax free?
Yes, you can acquire any number of replacement properties.

Can I exchange several smaller properties for a larger one?
Yes, you can sell any number of smaller properties and trade up to a larger one.

How do I exchange into a larger property (trade up)?
You trade up by getting a bigger loan on the new property, or adding cash, or equities in other properties, or notes carried back from the sale of other properties, etc. Done right, it's all tax free.

Can I refinance without blowing the tax free exchange?
Yes, you can refinance the property you are selling before you exchange, or refinance the property you are buying after you exchange, and the proceeds are tax-free..... the timing and contract dates are critical.

Can I carry back a loan on the property I'm selling and still have a tax free exchange?
Yes, the payments you receive are taxed as you get them, on an installment sale basis. The balance of your equity is exchanged tax free.

I've already sold my property. Can I still do an exchange?
Yes, provided your sale has not closed yet, simply contact a qualified intermediary and they will turn your taxable sale into a tax free exchange with some simple paperwork. You can do this right up until the day before closing.

 

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Important 1031 Exchange Guidelines

The sale and purchase of investment property can be done as a Delayed Exchange or a Simultaneous Exchange. Both qualify for tax deferment. There are important guidelines and pitfalls you need to be aware of if you want total tax deferment:

1. Like-kind Property
The exchange must be for like-kind property, in other words property also for use in business or investment, but it need not be for an identical use.

2. Equal or Greater Property Value
The fair market value of the Replacement property must be equal to or greater than the fair market value of the Relinquished Property.

3. Use All Proceeds From the Sale
You must use all of your exchange proceeds from the sale of the Relinquished Property to acquire your Replacement Property. It is also important to remember that you are not entitled to use any of the proceeds from the sale. IRS regulations require that the proceeds of the sale be held by a "Qualified Intermediary". You cannot leave the proceeds in an account to which you have even indirect access or control until the replacement property is acquired, such as a friend, employee, broker or even a CPA or attorney.

4. Equal or Greater Debt
The amount of debt (mortgage) undertaken in the purchase of the Replacement Property must be equal to or greater than the debt (mortgage) relieved in the sale of the Relinquished Property.

5. The Same Owner Rule
Whoever is the titleholder of the Relinquished Property must be the purchaser of the Replacement Property.

6. Identifying the Replacement Property
The Replacement Property must be identified within 45 calendar days from the sale of the Relinquished Property.

7. The Exchange Period
The purchase of the Replacement Property must be completed within 180 calendar days from the date of sale of the Relinquished Property.

These guidelines are to be used to help you effectuate a tax-deferred exchange. If you don’t meet all the guidelines, you may still do an exchange, but you may be subject to tax on the different. We highly recommend that you seek specific tax advice from your tax advisor or attorney particularly when attempting a partial exchange.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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Glossary

1031 Exchange - The tax deferred sale and purchase of properties that are like-kind for the benefit of deferred gain treatment.

Boot – Cash or mortgage relief received in an exchange, the result of which is a taxable gain.

Closing - The transfer of title of real property in a real estate transaction.

Constructive Receipt - The ability of the investor (exchangor) to exercise control over the proceeds or exchange equity resulting from the transfer of the relinquished property.

Exchange Equity - The cash and/or other property available at the time of closing on the sale of the relinquished property.

Exchange Period - The 180 day period in which the exchangor must complete their 1031 exchange by acquiring title to the replacement property. The 180-day period begins on the day title transfers on the relinquished property.

Exchangor- The taxpayer intending to defer the taxable gain on the exchange of investment property.

Gain - The taxable portion of the sale price.

Identification Period - the 45-day period for identifying the replacement property. The identification period starts on the day title transfers on the relinquished property.

Like-Kind – The properties being exchanged must be of the same asset class. Like kind is defined in the tax code as meaning “similar in nature or character, notwithstanding differences in quality or grade”. All real property is considered like kind and must be held for investment or held for productive use in a trade or business.

Relinquished Property - Investment property sold as part of an exchange.

Replacement Property - Investment property acquired as part of an exchange.

"Starker Exchange" - A term used to describe delayed, non-simultaneous, exchanges. Starker vs. United States (1979) established the delayed exchange concept.

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