The 1031 tax-deferred exchange is a method of temporarily avoiding capital gains taxes on the sale of an investment or business property. Those taxes could run as high as 15% to 30% when state and federal taxes are combined.
This property exchange takes its name from Section 1031 of the Internal Revenue Code. It allows an investor to replace one investment or business property with a like-kind property and defer the capital gains on the sale if the Internal Revenue Service's rules are meticulously followed. In theory, an investor could continue deferring capital gains on investment properties until their death, potentially avoiding paying taxes on them altogether.
It is a wise tax and investment strategy as well as an estate planning tool. The 1031 exchange has been considered as one of the most powerful wealth-building tool still available to taxpayers. It has been a major part of the success strategy of countless financial wizards and real estate gurus.
1984 Law Changes
After a series of liberal court decisions had given real estate investors wide latitude in the types of properties that could be exchanged and the time frames in which they could complete the exchanges, Congress passed changes to Section 1031 in the Tax Reform Act of 1984. This legislation further defined "like-kind" property and established a timetable for completing the exchange.
Only real property held for business use or as an investment qualifies for a 1031 exchange. A personal residence does not qualify and, generally, a fix-and-flip property also doesn't qualify because it fits into the prohibited category of a property purchased solely for resale. Vacation or second homes that are not held as rental properties usually do not qualify for 1031 treatment; however, there is a usage test under Section 280A of the tax code that may apply to those properties.
You should consider consulting a tax expert to see whether your second or vacation home qualifies under Section 280A. It may be if it's used as your principal place of business or is rented out, in whole or in part.
Land that is under development for resale does not qualify for tax-deferred treatment. Stocks, bonds, notes, and beneficial interests in a partnership are not considered to be a form of "like-kind" property for exchange purposes.
To qualify as a 1031 exchange today, the transaction must take the form of an "exchange" rather than just a sale of one property with the subsequent purchase of another. First, the property being sold and the new replacement property must both be held for investment purposes or for productive use in a trade or a business. They must be "like-kind" properties.
The following real estate swaps are examples of those that fit the requirement for a qualified exchange of "like-kind" property:
- An office in exchange for a shopping center
- A shopping center in exchange for raw land
- Raw land in exchange for an industrial building
- An apartment building in exchange for an industrial building
- A ranch or farm in exchange for an office building
Prior to 1984, virtually all exchanges were done simultaneously with the closing and transfer of the sold property (relinquished property) and the purchase of the new real estate (replacement property). In addition to the problems encountered when trying to finding a suitable property, there were difficulties with the simultaneous transfer of titles as well as funds. Not so today.
The delayed 1031 exchange avoids those pre-1984 problems, but stricter deadlines are now imposed. An investor who wants to complete an exchange lists and markets their property in the usual manner. When a buyer steps forward and the purchase contract is executed, the seller enters into an exchange agreement with a qualified intermediary who, in turn, becomes the substitute seller. The exchange agreement usually calls for an assignment of the seller’s contract to the intermediary. The closing takes place, and because the seller cannot touch the money, the intermediary receives the proceeds due to the seller.
At that point, the first timing restriction, the 45-day rule for identification, begins. The investor must either close on or identify in writing a potential replacement property within 45 days from the closing and transfer of the original property. The time period is not negotiable and includes weekends and holidays, and the IRS will not make exceptions. If the investor exceeds the time limit, the entire exchange can be disqualified, and taxes are sure to follow.
The investor can either identify three properties without regard to their fair market value or a larger number of properties so long as their aggregate fair market value at the end of the identification period does not exceed 200% of the aggregate fair market value of the relinquished property as of the transfer date.
If the three-property rule and the 200% rule are exceeded, the exchange will not fail if the taxpayer purchases identified replacement properties whose fair market value is 95% or more of the aggregate fair market value of all identified replacement properties.
Realistically, most investors follow the three-property rule so they can complete due diligence and select the property that works best for them and that will close. Generally, the goal is to trade up to avoid the transfer of "boot" and keep the exchange tax-free.
"Boot" is money from—or the fair market value of—any non-like-kind property that is received by the taxpayer through the exchange. Boot could be cash, a reduction in debt, or the use of sale proceeds for costs at closing that are not considered to be valid closing expenses. The rules governing boot in an exchange are complex, and without expert advice, an investor can inadvertently receive boot and end up owing taxes.
Buying the Replacement Property
Once a replacement property is selected, the taxpayer has 180 days from the date the relinquished property was transferred to the buyer to close on the new replacement property. However, if the due date for the investor's tax return, with any extensions, for the tax year in which the relinquished property was sold is earlier than the 180-day period, then the exchange must be completed by that earlier date.
Because there are no extensions or exceptions to this rule, it is advisable to schedule the closing for the replacement property prior to the deadline.
Since the law requires that the investor not touch the proceeds from the first transaction, the qualified intermediary acquires the replacement property from the seller at closing and transfers it to the investor after the transaction is completed.
By C. Grant Conness, President, 1031 Alternatives Group
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.
Frequently Asked Questions (FAQs)
What is a reverse 1031 tax-deferred exchange?
A reverse 1031 tax-deferred exchange is essentially the same transaction described above. The only difference that makes it a "reverse" tax-deferred exchange is that the second investment property is purchased before the sale of the first property.
What is taxable in a tax-deferred exchange?
The 1031 tax-deferred exchange strategy only defers taxes—it doesn't help you dodge them altogether. Everything that would normally be taxable is still taxable under a tax-deferred exchange. The only difference is that the taxes won't be paid in the year of the sale.