1031 Exchange

A 1031 Exchange, also known as a Like-Kind Exchange, is a method of structuring the sale of certain types of property so that the seller’s profit or gain is not taxed immediately. Instead, the property sold is replaced with another “like-kind” property. When properly structured, the seller’s profit or gain is deferred to a future date. A 1031 exchange can be an excellent way to sell an existing investment property and then purchase a new investment property while deferring capital gains tax penalties to a later date. Below, we provide helpful information to explain what a 1031 exchange is, how it works, and the rules and regulations involved.

This information is intended to provide a quick summary of 1031 exchanges and is not intended to guide you through the process. Be sure to consult with your accountant or legal counsel to see if a 1031 exchange may be an option for you. If you think a 1031 exchange may work well for your personal situation, we can help you get in touch with a qualified 1031 exchange accommodator.

What is a 1031 Exchange and How Does it Work?

Section 1031 of the IRS code is most often used for sales of real property. For real property exchanges under Section 1031, any property considered "real property" under the law of the state where the property is located will be deemed "like-kind" as long as both the old and new properties are held by the owner for investment, for active use in a trade or business, or for income production.

To fully benefit, the replacement property must be of equal or greater value, and all proceeds from the relinquished property must be used to acquire the replacement property. The taxpayer cannot receive the sale proceeds of the old property; doing so will disqualify the exchange for the portion of the sale proceeds the taxpayer received. Therefore, exchanges—especially non-simultaneous ones—are usually structured so that the taxpayer's interest in the relinquished property is assigned to a Qualified Intermediary before the sale closes. This way, the taxpayer does not have access to or control over the funds when the old property is sold.

At the end of the sale of the relinquished property, the closing agent (usually a title company, escrow company, or closing attorney) sends the proceeds to the Qualified Intermediary, who holds the funds until the transaction to acquire the replacement property is ready to close. Then, the proceeds from the sale of the relinquished property are deposited by the Qualified Intermediary to purchase the replacement property. After the replacement property is acquired, the Qualifying Intermediary delivers the property to the taxpayer, all without the taxpayer ever having "constructive receipt" of the funds.

The main idea behind the 1031 Exchange is that because the taxpayer is simply swapping one property for another of “like-kind,” there is nothing received by the taxpayer that can be used to pay taxes. Additionally, the taxpayer maintains a continuity of investment by replacing the old property. All gain remains invested in the exchanged property, so no gain or loss is "recognized" or claimed for income tax purposes.

Examples of a 1031 Exchange

An investor purchases a strip mall commercial property for $2,000,000. After six years, he can sell the property for $3,000,000. This results in a $1,000,000 gain, which the investor would need to pay capital gains tax on. However, if he reinvests the proceeds from the $3,000,000 sale into another property, he would not have to pay taxes on the gain at that time.

An owner of a detached house on 2 acres is transferred by his employer to another state. Instead of selling the home, which will no longer serve as his personal residence, he decides to rent it out for a period. After ten years, he chooses to sell it, but he also has a grown son who is about to attend college in another state. He then decides to purchase an apartment building in the college town for his son and other students to rent while studying. His house has appreciated from $700,000 to $900,000. Therefore, he arranges a 1031 Exchange and buys the new property, avoiding the capital gains tax at that time.

Important Notes

There are VERY IMPORTANT time limits to be aware of in a 1031 exchange. Contact us, and we can provide you with someone who is fully up to date with current laws and regulations.

Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.

The asset must be of like kind. Real property must be exchanged for real property, although a broad definition of real estate applies and includes land, commercial property, and residential property.

The replacement property must be identified within 45 days of the sale of the relinquished property. Up to three properties may be identified. The proceeds of the sale must be invested in a like-kind asset within 180 days of the sale. Restrictions are imposed on the number of Replacement Properties that can be identified as potential Replacement Properties.

Boot

Although it is not used in the Internal Revenue Code, the term "Boot” is commonly used when discussing the tax implications of a 1031 Exchange. Boot is an old English term meaning “Something given in addition to.” “Boot received” refers to the cash or fair market value of “Other Property” received by the taxpayer during an exchange. Money includes all cash equivalents, debts, liabilities, or mortgages of the taxpayer assumed by the other party, or liabilities tied to the property exchanged by the taxpayer. “Other Property" refers to non-like-kind property, such as personal property, a promissory note from the buyer, a promise to perform work on the property, a business, etc. There are many ways for a taxpayer to receive "Boot," even unintentionally. It is crucial for a taxpayer to understand what can result in boot if they want to avoid taxable income.

The most common sources of boot include the following:

Cash boot taken from the exchange usually appears as "Net cash received," which is the difference between the cash received from the sale of the relinquished property and the cash paid to acquire the replacement property(ies). Net cash received can occur when a taxpayer is "Trading down" in the exchange, meaning the sale price of the replacement property(s) is less than that of the relinquished property.

Debt reduction boot happens when a taxpayer’s debt on the replacement property is less than the debt on the exchanged property. Similar to cash boot, debt reduction boot can also occur during a "Trading down" in the exchange.

Using sale proceeds to pay for non-qualified expenses is another situation. For example, service costs at closing are not considered closing expenses. If proceeds from the sale are used for non-transaction costs at closing, it effectively equals the taxpayer receiving cash from the exchange and then using it for these costs. Taxpayers are advised to bring cash to the sale closing to cover expenses such as: non-transaction costs—like rent perorations, utility escrow charges, tenant damage deposits transferred to the buyer, and other charges unrelated to the closing.

Excess borrowing to acquire the replacement property also results in complications. Borrowing more than needed to close on the replacement property will not create tax-free funds at closing. The excess funds from the loan will first be applied toward the purchase. If the addition of exchange funds creates a surplus at closing, all unused exchange funds will be returned to the Qualified Intermediary, likely to be used for acquiring additional replacement property. Loan acquisition costs (origination fees and other related expenses) for the replacement property should be paid from the taxpayer’s personal funds at closing. Typically, taxpayers argue that these costs are paid out of the loan proceeds, but the IRS may view them as paid with Exchange Funds. This is a common stance among financing institutions as well. Currently, there is no official guidance from the IRS on this issue.

Received non-like-kind property from the exchange, in addition to the like-kind property (real estate).

Boot limitations: Exchangers are advised to follow the following guidelines:

Always trade "across" or up, but never trade down to avoid receiving boot, whether as cash, debt reduction, or both. The boot received can be offset by qualified costs paid by the Exchanger. Always bring cash to the closing of the replacement property to cover loan fees or other charges that are not qualified costs. (See above) Do not receive property that is not like-kind. Do not over-finance the replacement property; financing should be limited to the amount needed to close on the replacement property, plus exchange funds brought to the closing. The Three-Property Rule allows for any three properties regardless of their market values. The 95% Rule permits any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the total FMV of all the potential replacement properties identified. The 200% Rule allows any number of properties, provided the total fair market value of the replacement properties does not exceed 200% of the total FMV of all exchanged properties as of the initial transfer date.

Time Limits and Difficulties in Meeting Them

Frequently, the most difficult component of a 1031 exchange is identifying a replacement property within the first 45 days following the sale of the relinquished property. The IRS is strict in not allowing extensions.

A 1031 exchange is similar to a traditional IRA or 401K retirement plan. When someone sells assets in these tax-deferred retirement plans, the capital gains that would normally be taxable are deferred until the holder starts to cash out. The same principle applies to tax-deferred exchanges or real estate investments. As long as the money is reinvested in other real estate, capital gains taxes can be deferred. Unlike the retirement accounts mentioned earlier, rental income from real estate investments will still be taxed as net income is earned.

An alternative to a 1031 exchange for someone who wants to defer capital gains tax but does not want to continue holding property is a structured sale. This method offers both buyer and seller many benefits and is regarded as ideal for those looking to retire from or exit from the real estate or business market.

How a 1031 Exchange is Accomplished

The following sequence represents the order of steps in a typical 1031 exchange:

Hire a tax counsel or CPA and get advice from them.
Sell the property, including the Cooperation Clause in the sales agreement. "Buyer is aware that the seller's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish the same, at no additional cost or liability to buyer." Ensure your escrow officer or closing agent contacts the Qualified Intermediary to order the exchange documents.
Sign a 1031 exchange agreement with your Qualified Intermediary, naming the Intermediary as the principal in the sale of your relinquished property and in the purchase of your replacement property. The agreement must meet IRS requirements, especially regarding proceeds. An escrow amendment is also signed, naming the Qualified Intermediary as the seller. Usually, the deed is still prepared from the taxpayer to the actual buyer, a process known as direct deeding. The replacement property does not need to be identified at this stage.
Close the relinquished property escrow, with the closing statement showing the Qualified Intermediary as the seller, and deposit the proceeds into a separate, fully segregated money market account for safety and liquidity. The closing date of this escrow is Day 0 of the exchange, initiating the exchange timeline. You must send written identification of the replacement property’s address within 45 days and acquire the property within 180 days.
Send written identification of the replacement property’s address or legal description to the Qualified Intermediary on or before Day 45. It must be signed by all parties who signed the exchange agreement and can be sent via fax, hand delivery, or mail—preferably certified mail with return receipt requested to your Qualified Intermediary, the seller, or their agent, or an unrelated attorney, to obtain proof of receipt.
Enter into a purchase agreement for the replacement property, including the Cooperation Clause. "Seller is aware that the buyer's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with buyer to accomplish the same, at no additional cost or liability to seller." An amendment also signs the Qualified Intermediary as the buyer, with the deed from the true seller to the taxpayer.
Before the 180-day deadline and once all conditions are met, the Qualified Intermediary submits the exchange funds and proceeds to escrow, with the closing statement showing the Intermediary as the buyer. The final accounting from the Intermediary shows funds transferred in and out without the taxpayer taking constructive receipt.
The taxpayer files IRS Form 8824 with their tax return, along with any other required state documents.