Utilizing a 1031 Exchange is a valuable tool for real estate investors. Whether you want to leverage equity from your current investment, or there is a need to split ownership and cash out, a 1031 "like-kind" exchange might be the perfect strategy!
Follow this guide to understand the basics of this type of exchange, or click the hyperlinks below for quick answers.
*This guide is meant to provide general information, and cannot be assumed to apply to every situation. Any reliance on this information is at an investor’s own risk. All information presented should be independently verified. Consult your tax or legal advisor for information about your particular circumstances.
Contents
What are the benefits of a 1031 Exchange?
The main benefit is that it defers the taxes from the sale of a business or investment property. This is not a tax-free sale or acquisition, but a transfer of the tax burden to a new asset, which may or may not be recognized in the future.
Who can utilize a 1031 Exchange?
This is best for investors who plan to sell their current investment and purchase a similar asset.
Myths of a 1031 Exchange
The transaction has to close simultaneously
Investor/Exchanger has to find someone with whom to swap properties
The investor/exchanger must purchase the same type of investment
They are expensive
You cannot live on part of the exchanged property
More likely to trigger a tax audit
Investor/exchanger can have their attorney hold the funds
Investor/exchanger can self report to the IRS
Reasons to complete a 1031 Exchange:
You've already utilized all the depreciation value on your current property
Desire to leverage your current investment to purchase a higher valued asset
Problems with co-ownership partners
Desire to invest into a new geographic area
Desire to improve cash-flow
Consolidate or diversify investments
Acquire a property that can handle a higher debt
Sell one property to acquire multiple units to give to heirs
What taxes are deferred?
Short term capital gain from an asset held 1 year or less
Gains are taxed as regular income
Long-term capital gain from an asset held 1 year or more are subject to the following rates:
Incomes below $418,400 for individuals, or $470,000 if married:
15% of Capital Gains
Incomes above $418,400 for individuals or $470,000 if married:
20% of Capital Gains
Depreciation Recapture
Tax write-offs that were taken every year over the course of ownership
Taxed at 25%
A 3.8% tax on unearned income (includes profit from the sale of real estate) applies to anyone with an adjusted gross income of $200,000+ (individual) and $250,000+ (married couple)
What are the requirements for this type of tax exchange?
The basic requirements are to identify a "like-kind" asset within 45 days of closing the relinquished asset, reinvest all cash, and close on the replacement asset within 180 days from the date the relinquished asset closed. In order to meet the "safe-harbor" requirement, you will need a qualified intermediary to hold the funds until the replacement purchase is completed.
In order to take full advantage of this tax deferment, the transaction must be equal or greater in value, in both equity and debt. However, cash can be added to offset the debt if necessary.
What type of real estate qualifies for a 1031 Exchange?
Any property that is held and used as investment or trade/business. This can be exchanged for a like-kind property.
What does not qualify?
Primary residences, stocks, bonds, notes, cash, foreign property, or shares in a partnership or LLC, and inventory
What exactly does "Like-Kind" exchange mean?
"Like-kind" refers the character or use of the property, and generally all property is "like-kind" to other real property. This type of property can be improved or unimproved without affecting its classification. The property must be held as an investment, or used in business.
What is a Safe Harbor and why is it important?
A "Safe harbor" ensures the exchanger is not in actual or constructive receipt of the money from the relinquished property. In order to be compliant, and qualify as a Safe Harbor, the Exchange Agreement must restrict the exchangers from the right to receive, pledge, borrow, or benefit from the exchanged funds, except when:
After the end of the 45-day identification period, no replacement property has been identified, OR..
After the receipt of the replacement property to which the exchanger is entitled, OR..
If there is an identified replacement property, after the end of Identification Period of a material contingency. OR..
The end of the 180-day exchange period.
It is not a safe harbor when the exchanger has the immediate ability to : Receive, pledge, borrow or obtain the benefits of the money or real estate, before the end of the exchange period.
What is a Qualified Intermediary and why are they necessary?
It is essential to use a Qualified Intermediary when completing a valid 1031 exchange, as they preform several necessary functions in the process. By using a Qualified Intermediary, this creates a "safe harbor" that the IRS recognizes.
When choosing a Qualified Intermediary, look for a company that is a member of the Federation of Exchange Accommodators (FEA), has a long track record and financial strength. While there are no federal regulations, some states have certain requirements.
What does a Qualified Intermediary do?
Acts as a Principal
Holds the exchange proceeds
Prepares legal documents
Provides a quality service
Entities who are not qualified to perform as a intermediary:
The taxpayer's employee, attorney, accountant, Realtor or broker, investment banker, or relatives.
Documenting the Exchange
The Relinquished Property:
Purchase Agreement and title information provided to QI (Qualified Intermediary).
Exchange Documents Drafted (Agreement, Assignment of Purchase Agreement, Notice of Assignment)
QI sends the documents to the settlement agent
The settlement agent prepares the documents based on the QI instructions
Property transfers to buyer
QI receives the exchange proceeds
The Replacement Property:
Purchase Agreement and Title Information provided to QI
Exchange Documents Drafted (Assignment of Purchase Agreement, Notice of Assignment)
QI (Qualified Intermediary) sends the documents to the settlement agent
The settlement agent prepares the documents based on the QI instructions
QI sends the exchange proceeds
The replacement property transfers to the Exchanger
Who can make the exchange?
Disregarded Entities, which includes single member LLC, and revocable trust.
When it comes to completing the exchange, the properties must stay in the same ownership. Here's an example chart:
Relinquished Property Replacement Property
- CGA Partnership - CGA Partnership
- ABC Corporation - ABC Corporation
- The Sperry Revocable Trust - Ann and John Sperry as individuals
- John Sperry - Sole member of the Sperry LLC
- John Sperry 100% Ownership - John Sperry 20% TIC Ownership
Expenses That Can be Paid Through the Exchange
Exchange expenses are certain items that are paid at closing and will not result in a tax consequence. Those certain items include: Broker's commissions, appraisal fees required by the contract, exchange fees, transfer fees, recording and escrow fees, title insurance for the owners policy, attorney's fees accumulated in connection with the exchange.
Certain expense items do not fall under the Exchange Expenses category if they are not directly relating to the disposition of the relinquished property, or the acquisition of the replacement property. Such items include: Loan cost and fees, title insurance for the lender's policy, appraisal and environment investigation required by the lender, security deposits, prorated rents, insurance premiums and property taxes.
Any form of "cashing out" will be taxed. An example of "cashing out" would be using exchange funds to pay closing costs or issue credits that affect the price.
Another issue of concern is that paying certain expenses could be construed as impermissible. IRS regulations state that the exchange or taxpayer cannot have actual or constructive receipt of the exchange funds. The exchange could fail if there is improper receipt. It is highly recommended to have a tax advisor approve each closing statement due to the lack of IRS and case law guidance on this section.
Identification Requirements
3-Property Rule - Up to 3 properties, regardless of their value
200% Rule - Any number of properties having aggregate value, not more than 200% of relinquished property
95% Exception - Any number of properties at any value, so long as the taxpayer acquires 95% of the identified properties
Procedures for Property Identification
The identified property (or properties) must be delivered to a qualified party (e.g. Qualified Intermediary) of the exchange.
The identified property must be in writing and signed by the Exchanger
It must be site specific
It must be sent or delivered within the 45 day window.
If within the 45 days window, the identification can be revoked by the exchanger.
Exchange Types
Simultaneous (With/Without QI)
Delayed
Improvement (Build to suit)
Reverse
Reverse/Improvement
Improvement Exchanges
When it comes to improvement exchanges, the exchanger can improve the property to increase the property's value. In order for the tax deferral, enough of the improvements must be completed to attain equal or greater value and equity.
Improvement exchanges are structured similarly to a reverse exchange. An exchange accommodation titleholder "EAT" holds title for the replacement property while the improvements are being done. They will hold title for up to 180 days from the sale of the relinquished property. The cost of the improvements and construction is paid for by either the exchanger, a loan, or by using exchange funds.
Reverse Exchanges
Reverse exchanges have guidelines that must be followed:
Close on the replacement property prior to the relinquished property
Must be set-up before the replacement property closes
LLC is created by QI to acquire the replacement property, and "park" the property for a max of 180 days
This is more expensive, because it requires additional title, escrow and transfer tax fees.
If commercial property, it will most likely also require a phase 1 environmental report.
There are a few issues and benefits to this type of transaction such as: Capital, financing, time constraints, unforeseen market changes, time to acquire particular asset, and construction/ tenant improvements.
Primary Residence - IRC Section 121 Requirements
Some capital gains are excluded from the sale of a primary residence if one meets the following criteria:
You own the home
You've lived in the home as your primary residence at lease 2 years of the last 5 years
If single, the exclusion is $250,000
If married, the exclusion is $500,000
This exclusion can be used once every 2 years
If you have too much gain in your home, consider taking advantage of the Super Tax Break 1031/121. This applies to property first used for personal residence, and then rented. You can turn the property into an investment property by moving out, and renting the property for 1-2 years. Then, sell the property and complete a 1031 exchange.
Exclude up to $500,000 of gain (IRC 121), and
Defer tax on gain by completing a 1031 exchange.
Example of Primary Residence to a Rental:
Purchased home in 2015 for $500k, and used it as a primary residence for 3 years
Converted to rental for 2 years, and sold in 2020 for $1.4M, which is a gain of $900k plus 2 years of depreciation deducted.
Exchange into rental property for $900k, taking $500k cash out
$500k boot/gain is excluded under Sec 121, additional $300k gain (+ depreciation) is deferred under Sec. 1031
Can I live in the replacement property?
The property must be an investment first, and then a primary residence.
This has a $250k/$500k exclusion
Example of Rental to Primary Residence:
Purchased a rental home on 1/1/2010 and converted to primary residence on 1/1/2017
Primary residence for 2017 through 2018 and sold on 1/1/2019 for a gain of $500k
Five years of post-2011 use as a rental home (2012-2017) are unqualified use out of total 10 years of ownership (2010-2019)
Of the $500k gain, $250k cannot be excluded under Sec. 121 due to unqualified use. (5 out of total 10 year ownership)
Mixed use properties utilizing 121 and 1031
A property used as a personal residence, as well as investment property. Examples include a home office, a duplex with the owner residing in one of the units, or a farm or ranch where part of the property is owner-occupied.
When selling a mixed-use property, a portion of the gain from the sale of the personal residence is exempt from tax, and the remaining tax can be deferred under IRC Section 1031.
A tax advisor can help determine how to allocate the basis and gain between the sections of the property used for primary residence and investment.
Vacation Homes
A vacation home qualifies for exchange if:
You've owned the property for at least 24 months
Rent at Fair Market Rate for at least 14 days in every 12 month period.
Personal use less than 14 days, or 10% of time rented at the Fair Market Rate in every 12 month period.
It is possible that exchanges outside of these guidelines could still qualify. Consult your tax advisor or Qualified Intermediary for answers to your specific circumstance.
If the vacation home is the replacement property, it must be held for investment/productive use for a minimum of 24 months, rented at FMR for at least 14 days, and your personal use does not exceed 14 days or 10% of rental days
After 24 months, the property can be converted to the primary residence and Sec 121 exclusion can be used to exclude the gain
Must be held for 5 years after the exchange
Drop and Swap Transactions
When some or all parties want out
Real estate is deeded to partners (Known as a "drop")
Partners own the real estate directly
There is no tax on the "drop"
Parties want to do an exchange (known as a "swap")
Some parties may cash out, while others can reinvest
If a partnership is selling a property, and some of the parties want to reinvest, while others want to cash out, complications can arise. Under IRC 1031, partnership interests are not exchangeable, and the taxpayer who sold the property must reinvest it in a replacement property.
A solution to this problem is to dissolve the partnership prior to the sale, and distribute interest via tenants-in-common to the individual partners (this is what's considered the "drop"). The individual owners deed the property to the buyer while former partners exchange their interest ("swap") into a replacement property.
Drop and swap transactions are considered complicated due to a multitude of tax implications. Here are some tips you can follow, but we always recommend to work with a CPA or attorney to evaluate all of the tax issues:
Drop out of the entity as early as possible, especially before the closing of the relinquished property
Hold the replacement property for a sufficient amount of time before transferring it to another entity
Maintain records in order to establish evidence of the intent to hold the property as an investment property
When dropping from the partnership and into TIC, follow the criteria in Rev. Proc. 2002-22 (as soon as possible).
This basically mean sharing the profits and expenses on a pro rata basis
Examine case law in addition to Rev. Proc. 2002-22
When selling the relinquished property, enter into the agreement as separate individuals
Consider all tax implications of the alternatives
* California/FTB is a state agency that has disallowed drop and swap transactions, and only recently was there a successful case
Delaware Statutory Trust (DST)
Revenue ruling 2004-86 August 16, 2004
A DST is a form of trust created under Delaware law that allows multiple investors to own property with professional management. If structured correctly, the investors can trade in and out of the DST interest using a 1031 Exchange. Each owner owns a beneficial interest in the DST, and the DST owns one or more properties.
The advantages of a DST are investment diversification, and avoiding management hassles. It can also be an ideal hedge if your having difficulty finding the right investments, or if you still have a balance left in our exchange account after completing your exchange purchase.
The disadvantages are the lack of control on the asset, and required hold time. DST's are also limited to accredited investors.
TIC vs. DST
TIC
Deed of trust for undivided fractional interest
Up to 35 owners
Unanimous decision making
Can refinance
Property sold upon agreement of owners
DST
Beneficial interest in the trust
Up to 499 owners
Inability to refinance
Properties sold prior to loan or lease terminations
Related Parties
A good rule to follow: If at the start of the exchange related parties each hold like-kind properties but when the exchange is complete, only one party has a like-kind property, there's a strong chance you did something wrong!
Key Points
Purchase Like-Kind Property
45 day identification period
180 day exchange period
Purchase of equal or greater value
Spend time researching a qualified QI
At Sperry Commercial - Flint Brokers & Associates, we have worked with many clients in the disposition and/or acquisition stage of their 1031 exchange process. We have assembled an exceptional team of partners and advisors, and together, we can ensure that our clients meet their investment objectives. Give us a call today to discuss your specific circumstance, and determine if we might be the right fit for you.