Investment property owners need to review their portfolios regularly to identify new opportunities as the market changes. In many instances, owners may find they want to sell existing property in exchange for different real estate opportunities. In these cases, they should consider whether they want to take advantage of a 1031 tax-deferred exchange.
This type of procedure allows investment property owners to sell their properties for like-kind properties, all while deferring capital gains tax. If you’re interested in this type of opportunity, this article will provide a summary of the 1031 exchange, the rules that apply and the pros and cons of performing a 1031 exchange.
WHAT ARE 1031 EXCHANGES?
A 1031 exchange, also known as a Starker exchange or like-kind exchange, is a property exchange rule that allows real estate investors to buy and sell investment properties while deferring payment on all or some incurred capital gains taxes at the time of the exchange. The term “1031 exchange” comes from Section 1031 of the U.S. Internal Revenue Code (IRC), which allows for this procedure. You may even hear investors use this term as a verb, as in, “We should 1031 that building for this one.”
HOW DO 1031 EXCHANGES WORK?
While a 1031 exchange sounds simple enough, performing one can be tricky. A classical 1031 exchange involves a property swap between two individuals. However, this is rare, considering that finding someone with the type of property you want who is willing to exchange for your property is not always easy, quick or feasible. Unless they are lucky, most property investors wanting to perform a 1031 exchange must do what is called a delayed exchange. You may also hear this type of exchange referred to as a three-party or Starker exchange, named after the legal case that established the procedure. This type of exchange works using the following steps and rules:
1. Involve a Qualified Intermediary
Once you have decided to initiate a delayed 1031 exchange, begin by retaining a qualified intermediary. The qualified intermediary is a person or company with no stakes in the exchange that manages the funds involved. The intermediary holds on to the proceeds from the sale of your property, then transfers the funds to the seller of the replacement property or properties.
The reason for this third party is to allow for delayed exchanges and ensure the funds from the sale are held in a way that enables them to remain untaxable until the time limit for the 1031 exchange passes.
2. Identify a Property
The seller has an identification window of 45 calendar days to identify a property to complete the exchange. Once this window closes, the 1031 exchange is considered failed and funds from the property sale are considered taxable. Due to this slim window, investment property owners are strongly encouraged to research and coordinate an exchange before selling their property and initiating the 45-day countdown. Fortunately, investors have multiple identification strategies available, which are summarized in three rules:
Three Property Rule: Also known as the Three Property Identification Rule, the Three Property Rule allows investors to identify a maximum of three potential like-kind replacement properties regardless of their fair market value. After identification, the investor could then acquire one or more of the three identified like-kind replacement properties as part of the 1031 exchange. This method is the most popular 1031 exchange strategy for investors, as it allows them to have backups if the purchase of their preferred property falls through.
200% Rule: The 200% of Fair Market Value Identification Rule states investors can identify an unlimited number of like-kind replacement properties, provided the total value of all properties at the end of the period doesn’t exceed 200% of the relinquished property’s total net sales value. If an investor wants to perform a 1031 exchange on a property with a sales value of $1 million, they can identify as many replacement properties as desired as long as those properties’ total value doesn’t exceed $2 million. This strategy is often preferred by investors looking to acquire over three investment properties or seeking extra backup properties if a sale falls through.
95% Exception: The 95% Identification Exception states investors can identify an unlimited number of potential replacement properties with an unlimited fair market value, provided the investor acquires and closes on 95% of the identified market value. This technique is most often used by investors who exceed the 200% rule at the close of the identification period. Using this exception may be an intentional choice if the investor seeks to purchase multiple properties. It may also happen inadvertently from sudden property value increases. Either way, this gets around the 200% rule while still meeting 1031 exchange requirements.
It’s important to note that if the investor fails to identify properties or identifies more properties than allowed by the Three Property Rule or the 200% Rule and cannot apply the 95% Exception, then the 1031 exchange is considered failed.
3. Purchase a Replacement Property
Once the replacement properties are identified, the seller has a purchase window of up to 180 calendar days from the date of their property sale to complete the exchange. This means they have to purchase a replacement property or properties and have the qualified intermediary transfer the funds by the 180-day mark.
This window may be shorter if the due date of the income tax return for the tax year in which the previous property was sold falls within the 180-day window. In which case, the sale is due by the tax return date. If the deadline passes before the sale is complete, the 1031 exchange is considered failed and the funds from the property sale are taxable.
Another point of note is that the individual selling a relinquished property must be the same as the person purchasing the new property. The name must match between the tax returns and titles of the old and new properties for the exchange to qualify for the 1031 rule. The only exception to this rule applies to cases of single-member limited liability companies (SMLLCs).
The SMLLC may be treated as equivalent to the sole member of the organization. For example, if John Smith is the sole member of JSmith Investments, LLC, he may sell a property under his name, purchase it under JSmith Investments, LLC and still qualify under the 1031 code, as they are considered equivalent entities.
WHAT HAPPENS AFTER THE PROCESS
Once this process is complete, the seller does not have to pay the full amount of capital gains taxes they would have paid under normal circumstances. If they purchase replacement properties at or above the value of their relinquished property, they do not need to pay any taxes at all. Instead, those taxes are deferred indefinitely if you never perform another property sale.
If the seller performs another property sale after a 1031 exchange, they have a few options. They can sell the property without a 1031 exchange, in which case they will need to pay all current and deferred capital gains taxes. Alternatively, they can use the 1031 exchange rule again and defer the taxes on the subsequent sale as well. Under current regulations, there is no limit on how many times an investor can perform a 1031 exchange, provided they follow the rules and regulations outlined by the IRC.
Upon the death of the original seller, any deferred capital gains taxes from 1031 exchanges are erased. The properties purchased using the exchange then pass on to the seller’s heirs without the deferred taxes. Additionally, the heir receives the property with a step-up in basis. This means the property is inherited with a cost basis matching its current market value, not the value at which the property was purchased by the original seller.
For example, say that a property is originally purchased for $500,000. Years later, the property has a fair market value of $800,000 when the seller dies and passes it along to an heir. The heir inherits that property with a cost basis of $800,000, not the original $500,000. 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 when it is valued at $1 million, they would have to pay capital gains taxes on the $200,000 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.
WHAT PROPERTIES QUALIFY FOR A 1031 EXCHANGE?
In addition to the steps that must occur for an individual to perform a 1031 exchange, this type of exchange can only be used on certain types of properties. Does a second home qualify for a 1031 exchange? Can you 1031 into multiple properties? Below are the primary guidelines to determine whether properties qualify for a 1031 exchange:
1. The Productive Use Rule
Both the relinquished and replacement properties must be held for productive use in a trade or business. This means that only properties held for business or investment purposes may qualify for a 1031 exchange. This does not include personal properties, such as the seller’s primary residence. It also means that properties held solely for the purpose of selling, such as “flipped” properties, do not qualify for a 1031 exchange. There are some exceptions to this rule, however.
If you’ve heard of investment property owners using the 1031 provision to swap out vacation homes and residences, this is possible with some restrictions. As of 2004, Congress modified rules on 1031 exchanges so 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 a minimum of 12 to 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.
A similar rule applies to swapping out property to use as a primary home. As of an IRS safe harbor rule implemented in 2008, a property purchased under Section 1031 must meet the following requirements for two years after its purchase:
– The property must be rented to a tenant who is not the buyer for a minimum of 14 days per each 12-month period.
– The buyer cannot use the property for their own personal use for more than 14 days per 12-month period OR 10% of the number of days during which the property is rented to a tenant.
Provided that these rules are followed, primary residences may technically be bought and sold using a 1031 exchange. However, it is essential to ensure the property follows 1031 guidelines to the letter to avoid nullifying the exchange.
2. The Like-Kind Rule
One of the most important yet misunderstood rules for a 1031 exchange is the like-kind rule. Under this rule, the relinquished and replacement properties must be “like-kind.” This is often misinterpreted as the properties must be the same. Instead, this rule is very broadly defined and mostly refers to the nature or character of the properties rather than their grade or quality.
Under this rule, various types of real estate may be exchanged for one another. For example, unimproved real estate may be exchanged for improved real estate, as this relates to the quality of the property rather than the character under the 1031 guidelines. Similarly, farmland may be exchanged for a strip mall, industrial property or even rental property, as this also has less to do with the property’s character than the quality and grade.
This rule does prohibit certain types of exchanges that relate to the nature or character of the properties, however. For example, domestic properties may not be exchanged for international property. Additionally, the Tax Cuts and Jobs Act of December 2017 prohibited personal property like franchise licenses, aircraft and artwork from qualifying for 1031 exchanges, meaning only real property can qualify for a 1031 exchange.
3. Property Values and “Boot”
The IRS requires that the net market value and equity of the property or properties purchased be equal to or greater than that of the property sold to completely avoid capital gains taxes. On top of the properties’ values, expenses and fees are also included in these totals. Some expenses that can be paid with exchange funds include:
– Commissions and fees for brokers, qualified intermediaries, tax advisers and attorneys.
– Filing, finder and escrow fees.
– Title insurance premiums.
Expenses you cannot pay with exchange funds include property taxes, financing fees, maintenance costs, repair costs and insurance premiums.
If the replacement property’s total value, including the associated expenses, is less than that of the relinquished property, this results in what is called “boot.” The boot is the difference in value between the replacement property’s total cost and the relinquished property’s value.
While the presence of boot will not disqualify a seller for a 1031 exchange, it will require them to pay capital gains taxes on the boot amount. Typically, the qualified intermediary will pay out boot at the end of the exchange, after which point the seller is responsible for paying taxes.
One thing many sellers forget to consider in an exchange is loans. A mortgage is permissible on either side of the exchange and will count alongside the value of the respective property. If the replacement property’s mortgage is less than that of the property being sold, the difference is treated the same as cash boot.
EXAMPLES OF 1031 PROPERTY EXCHANGES
The rules for 1031 property exchanges can be confusing on the surface, but these guidelines are relatively broad. The broad definitions for what qualifies for a 1031 exchange allow for a wide variety of properties to be exchanged, which offers a higher range of opportunities for investors. Below are a few examples to help you understand what types of exchanges can and cannot be performed.
Some examples of exchanges that can be performed under the 1031 rules include:
– Exchanging any type of business properties for another, including farmland, raw land, rental property, industrial buildings, retail rental spaces and residential rental property.
– Exchanging property in one state for property in another state.
– Exchanging one large property for three smaller properties that add up to equivalent or greater value.
Some examples of exchanges that cannot be performed under the 1031 rules include:
– Exchanging primary residences that have not been converted into rental properties.
– Exchanging a primary residence for a business property of any type.
– 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 property in the U.S. for property in a foreign nation.
If you do not know whether your property will qualify for a 1031 exchange, work with a specialist in the field who can guide you through the process.
PROS AND CONS OF 1031 EXCHANGES
If you go this route and exchange your property, what are the advantages of a 1031 exchange? Before deciding to move forward with a 1031 exchange, it’s essential to understand the advantages and disadvantages. While it can seem like an attractive option, a 1031 exchange won’t work for all investment property owners.
Some 1031 exchange benefits include the following:
Pro #1: Grow Wealth Faster
1031 exchanges allow investors to defer the capital gains tax, so they can use the entire proceeds from a sale to purchase larger properties instead of paying a portion of those proceeds toward taxes. By minimizing the loss of purchasing power, investors can grow their wealth more quickly and open up more opportunities for investment.
Pro #2: Erase Debt Upon Death
The deferred taxes owed to the IRS after performing 1031 exchanges are erased upon the seller’s death. As long as the seller continuously performs 1031 exchanges to purchase larger properties through their lifetime, they can grow their wealth tax-free and pass it on to their heirs, who will inherit the properties without the deferred taxes.
Instead, the heirs receive the property at a stepped-up basis equal to the property’s fair market value at the time of inheritance. If the heir immediately sells the property at fair market value, they do not need to pay capital gains taxes since the sale price and basis value match. If the heir sells the property at a later date when it has increased in value, however, they will need to pay capital gains taxes for the difference between the basis value and sale price.
Alternatively, the heir can perform a 1031 exchange and defer any capital gains taxes when they sell the property at a higher rate.
While these benefits are attractive for investors, there are significant drawbacks to consider as well:
Con #1: Significant Rules to Follow
1031 exchanges must follow every rule and regulation to the letter, otherwise they will be considered failures. Investment property owners need to know and follow the 1031 guidelines, including what types of properties qualify, how many properties can be identified, what the purchasing guidelines are and more.
Any mistakes, such as failing to identify enough properties, identifying too many and failing to meet the 95% rule or missing crucial deadlines, can result in a failed exchange. For this reason, it is recommended to work with professionals who are highly familiar with 1031 exchanges to avoid falling outside the rules and harming the exchange’s success.
Con #2: 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.
While this can be a problem for first-timers, it is especially problematic for those who have performed several subsequent 1031 exchanges, as they have built up a hefty amount in deferred taxes. Upon this 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.
3. Depreciation Expenses
One significant issue that investors may encounter is depreciation. Depreciation is the amount of cost on an investment property that is written off each year due to wear and tear. Capital gains taxes are calculated based on a property’s original purchase price plus improvements and minus depreciation.
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. If depreciation is not accounted for in subsequent 1031 exchanges, investors may find that their rental incomes fail to keep up with depreciation expenses.
Reasons to Do a 1031 Exchange
While the drawbacks of 1031 exchanges may be daunting to newer investors, there are plenty of reasons to do a 1031 exchange and open up new opportunities for property ownership. Here are just a few situations in which a 1031 exchange may be an excellent choice for you:
– Exchange existing property for property with better long-term prospects.
– Exchange existing property for property that will diversify your assets.
– Exchange property you manage on your own for already managed property.
– Exchange multiple properties for one.
– Exchange one property for multiple ones.
– Exchange properties to reset depreciation.
– Expand real estate holdings for the sake of inheritances.
Of course, the main reason to perform a 1031 exchange is the tax deferral, which enables investors to maximize their purchasing power for replacement properties. Considering the rules and regulations involved, however, it is highly recommended that investors work with a professional with experience in 1031 exchanges to ensure the process is handled correctly.