Let’s start with the basics: what is a 1031 exchange?

A 1031 exchange is named after the Section of the Internal Revenue Code that defines its many rules and regulations (much like a 401(k) or 403(b) account). It helps real estate investors achieve one of the holy grails of investing: the deferral of capital gains taxes when selling an investment property, simply by reinvesting the proceeds of the sale into a subsequent, and similar, investment property.

Done correctly, the second real estate purchase assumes the cost basis of the original purchase, and capital gains taxes are deferred until the ultimate sale of the newly acquired real property. Of course, when it’s time to sell the second property, another 1031 exchange can be executed, so the business of paying taxes on your sales can, in theory, be deferred indefinitely. It’s not unheard of for savvy real estate investors to defer capital gains taxes for decades by stringing together a number of 1031 exchanges, year after year. Many professional real estate investors even use 1031 exchanges as a central component in their estate planning.

Sound simple?

Not so fast.

Since we know that 1031 exchanges offer a way to potentially defer capital gains indefinitely, we know that the root of the exchanges lies in the Internal Revenue Code, or the IRC, specifically, section 1031 of the Code. What may surprise many investors is that the exchanges are almost as old as the Code itself.

The first version of the IRC was adopted by Congress in 1918 as part of the Revenue Act of 1918, but did not allow for any tax deferral mechanism involving like-kind exchanges. Three years later, however, the Revenue Act of 1921 enabled investors to defer taxes on exchanges of securities and non-like-kind properties, enumerating these rights in Section 202(c) of the Code. Congress reversed itself quickly, eliminating the non-like-kind property provisions in the Revenue Act of 1924, and subsequently reaffirming deferral on like-kind exchanges in the Revenue Act of 1928, while also moving the relevant language to Section 112(b)(1) of the IRC.

It wasn’t until 1935 that like-kind exchanges began to more closely resemble the format we recognize today, as the Board of Tax Appeals approved like-kind exchanges that not only deferred capital gains taxes for the exchanges of similar assets, but introduced the Qualified Intermediary as an essential part of the transaction. Importantly, the “cash in lieu of” clause, which allowed for the proceeds of the sale of one property to be exchanged for a like-kind property (instead of requiring the exchange of the properties themselves) was also upheld.

Finally, the Internal Revenue Code of 1954 achieved its goal of consolidating the IRC provisions from 1939-1953, revising and renumbering the existing Code sections for overall ease of operations. In so doing, Section 112(b)(1) was reborn as Section 1031 of the Internal Revenue Code, laying the groundwork for the modern structure and functions of the exchanges that bear its name.

Subsequent evolutions of 1031 exchanges broadened their appeal and deepened their value to tax-averse investors seeking to capitalize on appreciated assets while minimizing the bite of taxes.

We’ve used the terms “1031 exchange” and “like-kind exchange” interchangeably; they are also frequently referred to as “Starker exchanges,” or “Starker trusts.” The name stems from a 1979 court case, Starker v. United States, in which the Starker family contested the IRS decision that their sale of timberland to a corporation, in exchange for a contractual promise to acquire and transfer title to properties identified by the Starkers within five years, did not qualify for a deferral of their income tax liabilities. The eventual decisions from the Ninth Circuit Court of Appeals set the precedent for what we now know as non-simultaneous, delayed like-kind exchanges. The Starker decisions also forced Congress to establish regulations governing non-simultaneous, delayed like-kind exchanges. As a result, the Deficit Reduction Act of 1984 introduced the 45-calendar-day identification deadline, as well as the 180-calendar-day exchange period. We’ll be discussing these important timelines in greater detail in future sections of this guide.

Not long after, the Tax Reform Act of 1986 changed the treatment of capital gains, resulting in all capital gains being taxed as ordinary income. Combined with a handful of accounting changes that accompanied the capital gains tax treatment, the 1031 exchange emerged as one of the few, and best remaining, income tax benefits available to investors, especially those with real property investments.

In 1990, the Department of the Treasury proposed rules which codified and finalized the 45- and 180-day timelines first established in 1984. They also provided guidance on constructive receipt issues, clarifying the definition of “simultaneous” and “improvement” exchanges under Section 1031, and further defining the eligibility of Qualified Intermediaries under Section 1031. These proposed rules were issued as final regulations in June of 1991, and remain an integral basis of 1031 exchanges today.

While other minor tweaks helped to form the current version of the 1031 exchange, the only other major development was the IRS’ decision to issue Revenue Ruling 2004-86, which paved the way for investors to take fractional ownership of interests in real property through Delaware Statutory Trusts, or DSTs. By ruling that DSTs qualified as a suitable replacement property solution for investors seeking to execute a 1031 exchange, it provided investors with an alternative to seeking out one or more real properties on their own, in theory facilitating increased participation in 1031 exchanges for investors.

As the foregoing history demonstrates, 1031 exchanges have existed for decades, and are likely to continue in some form for generations to come. Their evolution also demonstrates the ongoing need for investors to remain vigilant on any and all legislative attempts to strengthen this important tax benefit – or to weaken it. Multiple attempts have been made over the years to alter or even eliminate Section 1031 benefits, and while none has succeeded thus far, future attempts are virtually certain.

Our goal here, and in our Master The 1031 Exchange Masterclass, is not only to educate you on the current state of 1031 exchanges but also to keep you informed on any future changes that may take place.

The appeal of 1031 exchanges is obvious to savvy investors: the ability to defer, or even (by virtue of savvy estate planning) eliminate capital gains taxes, is a powerful financial incentive to consider an exchange. So let’s delve into the eligibility requirements for a 1031 exchange.

With 1031 exchanges offering such compelling tax advantages, the kinds of exchanges that are possible have evolved over the years. Decades ago, when the Internal Revenue Code first authorized the exchanges, there was only one kind, and it was extremely limiting. Now known as the simultaneous exchange, it required both the sale of the appreciated property and the acquisition of the subsequent property to take place at the same time.

Eventually, the code was modified to permit exchanges that allowed for some time to elapse between the sale of one property and the acquisition of the replacement property. These delayed 1031 exchanges are now the most frequent kind of exchange, and while they are relatively straightforward to structure and execute, they must be done specifically according to the rules laid out by the IRS. Any failure to follow even a single part of the procedure will result in the loss of the benefits associated with 1031 exchanges, even if all the remaining rules are followed to the letter.

Savvy real estate investors are therefore keenly aware of the following key elements of a 1031 exchange:

As delayed exchanges are the most common type of a 1031 exchange, it’s imperative for investors to fully understand the importance of following the timeline prescribed by the IRS in order to secure the tax benefits of successfully completing the exchange. Follow the timelines, and capital gains taxes can be deferred indefinitely, possibly even forever. But a single misstep along these carefully constructed timelines can result in the invalidation of the entire exchange, and a whopper of a capital gains tax bill to accompany it.

These Are Deadlines, Not Guidelines

The IRS is famously inflexible in general, and nowhere is this lack of wiggle room clearer than the strict deadlines of 45 days for the identification period, and 180 days for the exchange period. It matters not at all if day 45 or day 180 (or both) fall on a Saturday, Sunday, or legal holiday, nor does it matter if compelling personal circumstances, including a death in the family or other calamity, beset you as the deadline approaches. Failure to identify property by the end of day 45, or to receive the replacement property by the end of day 180, invalidates a 1031 exchange.

The only exception to this rule is if the IRS issues a Disaster Relief Notice, usually in response to a Federally declared disaster, an act of terrorism, or military action. In such cases, the IRS may elect to extend deadlines by up to 120 days. Even in such cases, it’s important to note that a declaration of disaster by a President, FEMA, or other Federal agency is not sufficient; the IRS itself must issue a formal Notice on its website.

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We have examined the mechanics of a typical delayed 1031 exchange, where an investor sells an appreciated investment property, and exchanges it within timelines stipulated by the IRS for at least one, or as many as three, replacement properties. This effectively defers payment of capital gains taxes on the initial investment indefinitely… and perhaps permanently.

Let’s take a closer look at the parties to a delayed 1031 exchange.

The Exchanger

The party that gets it all started is the exchanger, whom we have identified interchangeably as the investor in this guide. The exchanger initiates the 1031 exchange by selling their appreciated investment property, identifying it as a relinquished property in a 1031 exchange. The sale of the property is what begins the timelines involved in a 1031, or like-kind, exchange, with the entire process concluded within 180 days of the sale.

While we regularly speak of the exchanger as a person, it’s possible for the exchanger to be more than one person (for properties held jointly), or even an entity such as an LLC or other corporation.

Of course, if there’s a seller, that requires the existence of a buyer.

The Buyer Of the Relinquished Property

As with the exchanger, the buyer of the relinquished property can be a person, persons, or corporate entity. Like most real estate transactions, the sale of the relinquished property is complete when the appropriate paperwork is signed and the sale is paid. Unlike most real estate transactions, however, the exchanger does not immediately receive the proceeds of the sale, nor does the buyer immediately receive the property. Instead, both parties have included a paragraph in the sales agreement stipulating that the transaction is part of a 1031 exchange, and both property and proceeds of the sale are directed to the Qualified Intermediary.

The Qualified Intermediary (QI), or Exchange Facilitator

Selected by the exchanger, the QI plays a critical role in the like-kind exchange process; indeed, their presence is a necessary element to ensure that the 1031 exchange remains in compliance with the strict IRS guidelines. It’s difficult to overstate the importance of selecting a qualified and capable exchange facilitator. Their job begins with holding the proceeds of the original sale in trust, facilitating the paperwork required by the IRS in the identification period to identify the replacement properties, and of course also serving as the intermediary between the exchanger and the Seller.

The Seller of the Replacement Property

The replacement property seller, of course, is the entity (human or corporate) from whom the exchanger buys the replacement property to complete the exchange. As with the original sale, the proceeds do not pass directly from buyer to seller, but are transmitted to the QI, who ascertains that the process remains in compliance with Section 1031 and eventually wires the proceeds to the seller.

Bear in mind that, depending on the decisions made by the exchanger, the “seller” of the replacement “property” can actually be plural. The exchanger could choose to exchange their single property for more than one replacement property. In that case, the QI’s job becomes far more involved, as the exchange can involve a virtually unlimited number of sellers and properties, provided that each transaction closely follows the IRS’ three-property rule, 200% rule, and/or 95% rule. We’ll cover those three rules in much greater detail later in this guide, and of course we examine them extensively in the 1031 Exchange Masterclass.

Click here to download the Infographic: Who Are The Parties to a Delayed 1031 Exchange?

As we covered in some detail in Chapter 2 of this guide, 1031 exchanges are more than a century old, but they have evolved considerably over the years. Initially, all exchanges were confined to a single business day, during which two transactions (the sale of the relinquished property and the purchase of the replacement property) had to be closed simultaneously.

Like-Kind and Timelines

Following the Supreme Court’s 1979 Starker decision, however, the IRS acknowledged that the sale of one property and the purchase of a subsequent replacement property had to be like-kind, but not same-day, and they set about establishing timelines for which such delayed exchanges could take place and remain eligible for preferential tax treatment. Soon thereafter (in 1984), 45- and 180-day limits were imposed, requiring a replacement property to be identified and purchased, respectively, within those time frames.

Left unaddressed, however, was the question about the order of these events. Many assumed that it didn’t matter whether the sale of the relinquished property preceded the purchase of the replacement property, as long as both events were concluded within the timelines proscribed by the IRS. But while the IRS never challenged the legitimacy of the reverse exchange, in which the purchase of the replacement property precedes the sale of the property being replaced, they also neglected to confirm the validity of this procedure for nearly two decades, even while permitting them to take place over that time.

Formal recognition of the reverse exchange

Finally, the IRS issued Revenue Procedure 2000-37 to formally recognize the reverse exchange, or “parking” exchange, structure. And while the terminology involved in a reverse exchange is different from the delayed exchange, the two processes parallel each other closely.

Exchange Accommodation Titleholder, or EAT

As with any 1031 exchange, a reverse exchange requires the expertise of a third party so that the taxpayer avoids being in possession of both the relinquished and the replacement property at the same time. This third party, the Exchange Accommodation Titleholder (or EAT), plays a similar role to the qualified intermediary in a delayed exchange.

Qualified Exchange Accommodation Agreement, or QEAA

The structure of the parking exchange is spelled out in a qualified exchange accommodation agreement, or QEAA. The IRS safe harbor guidelines require both the existence of the QEAA, and the intermediary role played by the EAT.

A typical reverse exchange

A typical reverse exchange will proceed something like this:

1. The taxpayer finds an investment property they wish to buy. Typically, the purchase is completed, and the title is transferred not to the taxpayer, but to the Exchange Accommodation Titleholder (the EAT), since the taxpayer cannot own both the relinquished and replacement properties at the same time.
2. Within five business days of the transfer to the EAT, there must be a written and executed Qualified Exchange Accommodation Agreement (QEAA). The QEAA explicitly states the taxpayer’s intention that the property held by the EAT is part of a 1031 exchange.
3. Within 45 days of the “parking” of the replacement property to the EAT, the relinquished property or properties (up to three) must be identified, in writing.
4. Within 180 days of the transfer, both transactions must be completed. The EAT concludes the exchange by deeding the relinquished property to the buyer, and transferring the replacement property title to the exchanger.

Requirements

The parallels between the requirements involved in a delayed exchange and reverse exchange are obvious, and the same rules that apply to the replacement properties in a delayed exchange—the three-property rule, the 200% rule, and the 95% rule—all apply to the relinquished property or properties in a reverse exchange.

The language in Revenue Procedure 2000-37 acknowledges that most reverse exchanges involve the taxpayer parking the replacement property with an EAT while identifying the relinquished property and arranging for its sale. This is also known as the “exchange last” method. Depending on the circumstances, however, taxpayers may find it advantageous to use an “exchange first” method, parking the relinquished property with the EAT until the taxpayer is ready to complete the exchange (with a hard limit of 180 days, of course).

Factors

Any number of factors will determine which approach is best for the taxpayer, including the funding being used to acquire the replacement property (since the relinquished property has yet to be sold), the existing equity in the relinquished property, the presence of liens on the relinquished property, or the taxpayer’s intention to make improvements on the replacement property.

Since IRS regulations prohibit the use of exchange funds to make improvements on a property they already own, for example, a taxpayer seeking to make improvements on a replacement property would have to park the replacement property. They could then enter into an Improvement, or Build to Suit, exchange, and while the replacement property is parked with the EAT, improvements can be completed within the 180-day period. This would enable the EAT to ultimately complete the exchange by transferring the replacement property back to the taxpayer at the higher improved value.

Increased flexibility

Reverse exchanges are inherently more complex than their more straightforward delayed exchange counterpart, and they carry no increased tax benefits beyond any other form of 1031 exchange. More than anything, they offer increased flexibility for taxpayers whose individual circumstances dictate their need for them.

Working with a highly qualified advisor is a must here, and taxpayers seeking a more in-depth look at 1031 exchanges of all kinds would benefit tremendously from our 1031 Exchange Masterclass.