How to understand 1031 Exchanges
In a Nutshell, a 1031 Exchange involves business or investment property being sold and the proceeds re-invested into another business or investment property. Internal Revenue Code Section 1031 will not recognize either a gain or a loss for tax purposes.
IRS 1031 Exchanges originated with the Revenue Act of 1921. This law defers the payment of capital gains taxes with every exchange. The reason for the deferment is when a property owner reinvests the sales proceeds into another property, the economic gain from the sale is not realized. The taxes continue to defer with future exchanges until the property owner receives the sales proceeds.
In essence, the owner only realizes a “paper” gain in a 1031 Exchange and not a “taxable” gain.
Definition of Like-Kind Properties
People often become confused with the phrase “like-kind properties”. Some erroneously think that investment land can only be exchanged for similar raw land investments. Others wrongfully think that a sale of an apartment building can only be exchanged for another apartment building.
The IRS allows the sale of any type of business or investment property exchanged for any kind of business or investment properties. For instance, if you sell an apartment building you can purchase raw land for investment purposes, or a single-family home rental, or a hotel, or a commercial building. Even multiple properties from the sale of only one.
While a 1031 Exchange occurs with different types of properties, this article only focuses on real estate.
Benefits of a 1031 Exchange
Section 1031 exchanges are one of the few legal techniques used to postpone (defer) and even eliminate paying taxes on the sale of qualified real properties.
Deferring the taxes leaves you with more money to invest in other real properties. Consider it an interest-free loan from the federal government.
In addition, the IRS also allows the postponement of depreciation recapture from the gains.
You can dispose of real properties and acquire others to reallocate your investment portfolio without paying any taxes on the gains.
Requirements for a 1031 Exchange
The following types of real properties excluded from capital gains tax by using a 1031 Exchange include:
Business properties (like income-producing real properties like rentals, hotels/motels, commercial buildings); and
Investment properties (like raw land, real properties held for investment purposes).
Proper Purpose: The real properties sold and acquired must be held for productive use in a business or investment. Acquiring real property for immediate resale (like a fix and flip) do not qualify. The personal residence of a taxpayer does not qualify.
Holding Requirement: Properties must be held for at least “one year and a day” to qualify for a 1031 Exchange.
Like-Kind: The replacement property must be similar (like-kind) to the one sold. Not exactly alike. Selling any business or investment real property with the sales proceeds used to purchase other business or investment real properties qualifies. The sale of U.S. real properties requires the purchase of other U.S. real properties.
Equal or Greater Value: The replacement properties must be of equal or greater value than the one sold. For example, if you sell a qualified property for $1 million, you must purchase one or more qualified properties totaling at least $1 million.
Equal or Greater Equity: In addition, the replacement properties must carry debt equal or greater than the sold property. For instance, if your $1 million property included $250,000 loans, the replacement properties must likewise maintain at least $250,000 in debts.
Exchange Requirements: An “exchange” must occur between the sold real property and the ones purchased as replacements. You cannot sell a business or investment property for cash and use the proceeds to buy replacement properties. The sales proceeds must never be in possession of the seller. While the IRS allows for the sales proceeds to be held in “trust” by a neutral third-party, most exchanges use a “Qualified Intermediary” to facilitate the 1031 exchange.
Definition of a Qualified Intermediary
The Qualified Intermediary must be a neutral third-party with no connection or relationship with the property owner. This precludes the owner’s accountant, agents, attorneys, bankers, brokers, employees, family members, partners, etc.). Professional Qualified Intermediary companies exist all across the U.S. Most are attorneys, accountants, escrow officers, and other professionals. The IRS Treasury Regulations created a “Safe Harbor” of Qualified Intermediaries to facilitate 1031 Exchanges. Sometimes, they are called “exchange facilitators” or “accommodators”.
As long as the Qualified Intermediary takes control of the sales proceeds at the closing of the sale and keeps the proceeds away from the seller, the IRS recognizes the exchange. Control of the sales proceeds occurs in two ways:
1. Trust: A written Trust Agreement between the seller and the Qualified Intermediary instructing the escrow company to allow the intermediary control of the funds at closing.
2. Double Deeding: The seller initially deeds the property to the Qualified Intermediary who then deeds the property to the buyer and takes control of the funds at closing.
The funds held by the Qualified Intermediary in trust at a bank or financial institution waits for the seller to locate and purchase replacement properties. Then, the funds pay for the replacement properties.
Important 1031 Exchange Timing Requirements
45 Day Rule: When the sale of the owner’s property closes, the seller only has 45 days to identify potential replacement properties. The eventual purchases must be on that list. Some sellers provide a long list of properties copied from the current MLS listings.
180 Day Rule: Again, starting with the day of closing, the seller only has up to 180 days to complete the purchases for all replacement properties.
Failing to comply with one of these deadlines results in the 1031 Exchange’s failure subjecting the taxpayer to capital gains tax (and other taxes) as if a simple sale occurred.
Ending 1031 Exchanges
Two options exist for ending your 1031 Exchanges:
1. Cashing Out
Eventually, some investors decide to quit the exchange game. They simply receive the sales proceeds from their last sale.
Taxes: The taxes they owe the IRS from the first sale to the last accumulate. The “cost basis” carries through to the last sale where all previous exchanges add up to a large cost basis. However, tax experts advise that cashing out at the end may result in greater tax savings than paying taxes for each sale. Of course, it depends on the capital gains, corporate, and income tax rates in effect at the last sale.
2. Pass Away and Pass It On
As the old saying goes, “Death and taxes are inevitable”. However, that may not be the case here. When you pass away, all your real estate holdings go to your heirs. The tax laws allow for a “stepped-up basis” meaning the taxes owed simply disappear. Unlike cost basis adding up through every exchange, the inheritance “stepped-up basis” rule allows your heirs to sell at market value with no taxable gains.
For example, after numerous 1031 exchanges, the adjusted cost basis amounts to $300,000 with the value of your properties worth $3 million. If you sold the properties just before passing away, the taxes would be on the $2.7 million gain. However, once you pass away, your estate passes to your heirs and the basis becomes the fair market value of $3 million. If your heirs sell the properties for $3 million, no taxes due.
How to understand 1031 Exchanges as explained here provides useful tax savings tips for business and investment real properties.
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