1031 Exchange

A 1031 exchange is a powerful tax-deferment strategy for real estate held as an investment. It allows an investor to sell a property without paying capital gains on the sale as long as the equity is applied to a “like-kind” purchase. The tax is merely deferred—not forgiven. However, this strategy allows owners to reinvest real estate equity several times over a lifetime without paying taxes on their gains.

With the tax savings, investors have the potential to build wealth faster. The 1031 exchange rules invigorate communities by encouraging reinvestment: When one property is sold, more are purchased. Investors may use tax-deferred exchanges throughout their careers to buy bigger or better properties, to diversify their real estate investment portfolio, or to reset the clock on the real estate depreciation income tax deduction.

As an example of a first 1031 exchange, Ken purchased a condo five years ago for $200,000 with $20,000 down. He used it as a rental property for the past three years. Over the time of Ken’s ownership, the value of the condo has appreciated to $305,000. He’d like to better leverage his equity. If he sold the property and kept the approximately $100,000 profit, he could owe capital gains taxes of 15 to 20 percent. However, since it has been a rental property, Ken’s sale qualifies for a 1031 exchange. He can buy one or several investment properties, defer the tax, and invest the entire $100,000. Ken would only pay capital gains taxes on any portion of the $100,000 not used to purchase a new property or properties.  A 1031 exchange can be a tax-efficient strategy to preserve capital and, over time, build a legacy investment portfolio.

A replacement property must be “like-kind.” Fortunately, “like-kind” is broadly defined according to nature or characteristics—not quality or grade. Most types of real estate are considered like-kind. For example, a residential rental house is like-kind to a five-unit apartment building, vacant land, or even a strip mall. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Property purchased using a 1031 exchange must be held for investment and not resale or personal use, usually for a minimum of two years after the close of escrow.

Several 1031 exchange rules must be met to qualify for the deferred tax.

Rule 1: Like-Kind Property

The property sold and the property acquired must be “like-kind.” Most U.S. real estate investments will qualify. One property can be exchanged for varied replacement properties, and multiple properties can be reinvested into one larger property.

Rule 2: Greater or Equal Value

The total value of acquired properties must equal at least 95 percent of the sold property’s value. The sale of one property for $1,500,000 can be exchanged into three properties valued at $800,000, $300,000, and $600,000 because the total value of the replacement properties exceeds the price of the original sale. Understanding that real estate transactions come with significant fees, closing costs such as inspections and broker fees are counted toward the total value of the new property.

Rule 3: Investment or Business Property

A 1031 exchange is only applicable for investment or business property—not personal property or a primary residence. A former primary residence that is now a rental usually requires a minimum of two consecutive years as 100 percent rental property to qualify. One interesting case is the sale of a four-unit property in which one unit is owner-occupied. In this case, the sale can be treated as a three-quarters investment property and one-quarter primary residence.

Rule 4: 45-Day Identification Window

Once the first property closes escrow, the seller has 45 calendar days to identify up to three potential replacement properties. Experts recommend submitting offers on each replacement property and doing as much due diligence as possible before the 45-day countdown is over. An exception to the three property limit is known as the 200 percent rule. Here, the investor can identify any number of properties as long as the value of all combined is less than 200 percent of the first property’s sales price. In this case, if a property sold for $2 million, any number of replacement properties could be listed as long as their total value adds up to less than $4 million.

Rule 5: 180-Day Purchase Window

Including the 45 days to identify qualifying replacement properties, the investor has a total of 180 days to complete the purchase.

Rule 6: Same Taxpayer

The tax return and name appearing on the title of the sold property must be the same as the tax return and title holder of the new property. The 1031 exchange is not an opportunity to transfer property between owners or entities. The same seller must purchase the new property.

Rule 7: Use a Qualified Intermediary

A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they are transferred to the seller of the replacement property. The qualified intermediary is a neutral third party and can have no other formal relationship with the parties exchanging property. If an investor were to take possession of the sales proceeds before closing on the replacement property, no 1031 exchange would be possible, and taxes would be owed on the sale.

There are several types of 1031 exchanges. The four primary types are Simultaneous, Delayed, Reverse, and Construction.

Simultaneous Exchange

In a simultaneous exchange, the replacement property is identified and under contract before closing on the first property. The replacement property can close within a day of the first sale. In this case, the use of a qualified intermediary or 1031 exchange company is not necessary. The escrow company from the first sale can transfer proceeds directly into the escrow account for the new purchase. A simultaneous exchange also applies when two parties “swap” deeds.

Delayed Exchange

The delayed exchange is by far the most common. It occurs when the investor relinquishes the original property before targeting replacement property. The delayed exchange is subject to the 45-day identification period and the 180-day deadline to close escrow.

Reverse Exchange

In a reverse exchange, the investor purchases a property for cash and then identifies a property to sell to exchange into this newly acquired property. On paper, this type of exchange seems simple: buy first and sell later. What limits a reverse exchange is that it requires all cash for the purchase until the 1031 exchange proceeds can be applied. A failure to adhere to the 1031 exchange rules can result in a forfeit of the exchange. With a reverse exchange, investors have 45 days to identify “the relinquished property” to be sold, and a total of 180 days to close the sale.

Construction or Improvement Exchange

The construction exchange allows investors to improve the replacement property using the exchange equity. In this case, the entire exchange equity must be spent on completed improvements or as down payment by the end of 180 days.

An investor who continues to reinvest using the 1031 exchange passes an exciting advantage to his or her heirs—the deferred taxes are erased. Inherited property obtained through a 1031 exchange transfers to the heirs at the stepped-up market-rate value, and all deferred taxes are forgiven.

A 1031 exchange offers the significant advantage of deferring capital gains taxes, permitting savvy real estate investors to leverage equity.