What Is a 1031 Tax-Deferred Exchange?
Basics that Constitute a 1031 Tax-Deferred Exchange
By C. Grant Conness, President, 1031 Alternatives Group
Many investors have asked what exactly is a 1031 exchange, what are the guidelines and timelines, and can you legally defer your capital gains taxes? I thought it would be beneficial to answer some of your most common questions in this article.
What is a §1031 Exchange?
A §l031 Exchange is a transaction in which a taxpayer is allowed to exchange one investment property for another by deferring the tax consequence of a sale. The transaction is authorized by §1031 of the IRS Code.
The IRS Code actually reads: "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 such property is exchanged solely for property of like kind, which is to be held either for productive use in a trade or business or for investment."
Requirements for a 1031 Exchange
- Timelines for a 1031 ExchangeThe investor (or exchanger) must follow the strict 45- / 180-day guidelines for an exchange. Once the exchanger sells his/her property (relinquished property) he/she has 45 days to identify property(s) of equal or greater value. Once identified, the exchanger has 180 days from the day he/she sold their property to acquire the property(s) identified (or 135 days from the end of the 45-day period).
- Like-Kind Property in a 1031 ExchangeThe investor must acquire "like-kind" property. This means that it must be other qualifying forms of real estate. For example, the exchanger could sell a duplex and purchase a commercial property, or he/she could sell a piece of land and buy an apartment building. The property just needs to be "like-kind."
- Exchange Property Held for InvestmentThe property sold (relinquished property) and the newly acquired property (replacement property) must be held for investment or business purposes. Therefore, you cannot sell your primary residence and buy an investment property, nor could you sell and investment property and purchase a primary home.
- Equal or Greater Debt and Equity in a 1031 ExchangeIf the exchanger sells a property for $1 million, in which $500k was equity and $500k was debt, then the exchanger needs to purchase $1 million or more worth of property. Furthermore, the exchanger needs to use all the equity and replace all of the debt to defer 100% of the capital gains taxes.
- The exchanger may add additional proceeds to the new purchase if he/she wishes and the exchanger can take on additional debt if desired as well. If the exchanger does not wish to use all of the sales proceeds he/she may do a partial exchange and pay the applicable capital gains taxes on the difference. This is referred to as "boot."
- Constructive Receipt and Qualified Intermediary for a 1031 ExchangeThe exchanger may not receive cash from the sale. This is known as "constructive receipt" and would trigger a taxable event on those monies received. According to the IRS safe harbor provisions, the exchanger must use a Qualified Intermediary or QI to facilitate the 1031 transaction.
- The QI is an independent 3rd party (not your attorney, agent, broker or CPA) who holds the sales proceeds and purchases the replacement property on your behalf. It is extremely important in today's environment to associate only with reputable, insured and bonded qualified intermediaries.
- 1031 Exchange RiskAs with any investment in real estate, there are risks associated with Delaware Statutory Trusts and / or Tenants in Common ownership. It is not possible to address all relevant risk factors in this forum. Risk factors are outlined in the Private Placement Memorandum for each offering. Investors should thoroughly understand all risk factors and discuss them with their financial representative prior to investing in a Delaware Statutory Trust or Tenants in Common Exchange.
One of the problems I have encountered when representing sellers who receive offers from a 1031 exchange investor is we don't know if they are planning to close escrow. They might be naming 3 different properties or writing offers on a bunch of different homes just to see what gets accepted. Then, after they have a bunch of accepted offers, they choose the one they want to buy, which means canceling the others. Lawyers say this kind of practice violates good-faith covenants inherent in contracts, but it doesn't stop it from happening.
Ask the agent if this is the only offer.
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, Elizabeth Weintraub, CalBRE #00697006, is a broker-associate at Lyon Real Estate in Sacramento, California.