What Is a 1031 Tax-Deferred Exchange?
Like-kind property exchanges can defer capital gains
In most cases, a 1031 Exchange is a tremendous opportunity to defer capital gains, state, and income taxes on property. However, most investors have questions about preliminary and basic guidelines and timelines.
1031 Exchange Basics
A 1031 Exchange transaction is governed by IRS Code 1031. It allows an American taxpayer to exchange one investment property for another while deferring the tax consequence of the sale.
Section (1031(a)1 provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is to be held either for productive use in a trade or business or for investment.”
These are the IRS explanations for a 1031 Exchange:
Timelines: The investor, also known as the exchanger, must follow unbending rules for the transaction. Specifically, once a transaction is initiated by the sale of a relinquished property, the exchanger has 45 days to identify real estate that is the equivalent in value or greater. At the end of the 45-day period, the new or replacement property must be acquired within 135 days.
Like-Kind Property: Acquiring "like-kind" property means the new property must be a qualifying form of real estate. For example, the exchanger could sell a condo and purchase land or buy a rental home and sell an apartment building. However, the tax overhaul that took effect on Jan. 1, 2018, has redefined like-kind to make it more restrictive.
The IRS states on its website that “the Tax Cuts and Jobs Act, passed in December 2017, made tax law changes that eliminated exchanges of personal or intangible property such as machinery, equipment, vehicles, artwork, collectibles, patents, and other intellectual property and do not qualify for nonrecognition of gain or loss as like-kind exchanges.”
“Meeting the criteria is harder since the new tax law but there are still less usual things that can meet the criteria,” said Lora J. Hoff, a certified financial planner (CFP) in Dallas, Texas, who helps her clients find suitable exchange properties.
For example, an acre of land that contains oil and gas reserves and certain reservoir, irrigation stock, or mutual ditch exchanges, remains eligible for a like-kind exchange.
Exchange Property Held for Investment: The relinquished property and the replacement property must be held for investment or business. As a result, a primary residence cannot be included in an exchange for another investment property, nor can an investment property be sold to purchase a primary home.
“Investors are basically deferring their capital gain and most want to continue to defer it as long as possible but, theoretically, if you deferred it, bought the new property, and then found some compelling reason to sell it, you could do it,” said Hoff.
Equal or Greater Debt and Equity in a 1031 Exchange: If the exchanger sells a property for $1 million, in which $500,000 was equity and $500,000 was debt, then the exchanger needs to purchase $1 million or more worth of property. Further, the exchanger needs to use all the equity and replace all the debt to defer 100% of the capital gains taxes.
Under 1031(d), as stated on the IRS website, the basis of property acquired in a 1031 exchange is the same as the basis of the property exchanged, decreased by any money the taxpayer receives and increased by any gain the taxpayer recognizes.
“You can always have more debt,” according to Hoff. “The IRS says you just can't go into an exchange with less debt.”
There is the option for a partial exchange when the investor does not desire to use all of the sale proceeds, but this does require paying the applicable capital gains taxes on the difference.
Constructive Receipt and Qualified Intermediary for a 1031 Exchange: If an exchanger receives cash from the sale, it triggers immediate taxation called "constructive receipt” unless the exchanger has involved a Qualified Intermediary (QI) to facilitate, according to IRS safe harbor provisions.
“Money is held in escrow with a qualified intermediary to ensure that the exchanger did not take constructive receipt of the proceeds until the cash is transferred from the relinquished property into the replacement or future property,” said Hoff.
The QI is preferably a fully vetted, reputable, insured, and bonded independent third party—not the exchanger’s CFP, attorney, agent, broker, or CPA.
“For a minimal fee of $300 to $500, most title companies will act as QI as a service,” Hoff said. “It’s mostly paperwork and ensuring the transaction is completed properly but a QI is worth it if you will potentially keep the money in an investment property.”
Risks Involved With 1031 Exchanges
“You have more risks with the Tenants in Common ownership because there are multiple people involved and it’s difficult to get a consensus on agreements,” according to Sterling D. Neblett, a financial adviser in McLean, Va.
Unlike a Tenants in Common ownership, a DST’s decisions are handled by a trustee and no vote is needed.
Risk factors are outlined in the Private Placement Memorandum (PPM) for each exchange offering, which is created by the real estate company that is listing the investment. Well-known real estate companies that list exchange investments include Inland Capital in Spokane, WA, and Capital Square in Richmond, VA.
Investors should thoroughly understand all risk factors and discuss them with a professional prior to investing in a Delaware Statutory Trust or Tenants in Common Exchange.
One common problem is the buyer who writes offers on multiple properties but only intends to purchase one. While this violates good-faith covenants inherent in contracts, it doesn't stop it from happening. Ask the buyer's agent if yours is the only offer being made.
For more information, consult with a real estate professional, a CPA, attorney, or CFP.
This material is neither an offer to sell nor the solicitation to purchase any security. The information is for discussion and information purposes only. It is not intended to replace competent legal, tax, or financial planning advice. The applicable tax codes apply to and relate to federal law only. Individual states may have their own additional tax codes. Please contact the appropriate tax and legal professional in your state. This information is provided from sources believed to be reliable but should be used in conjunction with professional advice that is consistent with your personal situation.
At the time of writing, C. Grant Conness is the president of 1031 Alternatives Group in Fort Lauderdale, Fla.