What Is A 1031 Exchange?
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.
Potential Pitfalls of a 1031 Exchange
While the potential benefits of a 1031 exchange are compelling enough to encourage any real estate investor to consider them, there are many potential pitfalls to a 1031 exchange.
These can involve:
- the timing of the sale and purchase of the real property in question
- the nature of the property being sold as well as the one being bought to replace it
- the eligibility (and ineligibility) of certain kinds of investment properties
- how the proceeds of each transaction are handled
- how to address discrepancies in value (since one property is rarely exchanged for another with its exact value)
- the process of identifying suitable properties for purchase after deciding to sell the original piece of investment real estate
These are only some of the areas in which an unaware real estate investor may run afoul of Section 1031, and any one of these critical errors could be enough to render the exchange ineligible for the valuable benefits offered by the IRS, even if all of the other rules are followed to the letter.
Know and Understand The Rules of a 1031 Exchange
What is true of most real estate investments is doubly true of the 1031 exchange: it is critical to know and understand the rules surrounding these transactions, and essential for even the most experienced real estate investors to enlist professional help in following them all. In the field of 1031 exchanges, such pros are known as qualified intermediaries, exchange facilitators, or exchange accommodation titleholders, and their importance to a successful, IRS-compliant transaction cannot be overstated.
Reasons Why An Investor May Consider A 1031 Exchange
There are many different reasons why an investor may consider using a 1031 exchange, such as:
- They may be seeking to consolidate several properties into one (or, conversely, they may be looking to sell one investment property and replace it with three or more alternatives).
- They are hoping to upgrade their investment property or to invest in one with potentially greater investment returns.
- They might even have a goal of transforming a second home, or a vacation home, into an investment property via a carefully constructed 1031 exchange.
The factor common to all of these diverse factors is: the deferral of capital gains taxes.
That’s why I’ll be addressing every critical aspect of 1031 exchanges in this Guide to A 1031 Exchange, not only to encourage investors to consider these exchanges carefully in lieu of paying a potentially exorbitant and possibly avoidable capital gains tax, but to educate investors about the process so that they are able to take full advantage of something that the IRS rarely offers (and never offers without strings attached): a valuable tax break!
History of 1031 Exchange
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.
Who is Eligible for A 1031 Exchange?
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.
Requirement #1: The first requirement seems simple enough: to be eligible for a 1031 exchange, you must be a real estate investor, in possession of an appreciated piece of real property.
Let’s start with the simplest word: you.
For the purposes of a 1031 exchange, “you” can certainly be an individual investor. But you can also be a partnership (general or limited), a corporation (“C” or “S”), a trust, a limited liability company (LLC), or virtually any other tax-paying entity. In short, if you can own investment real estate and pay taxes on it, you can structure a 1031 exchange when selling the property in question.
Requirement #2: Both properties in the exchange—the one being sold, and the one being acquired—need to be investment real estate.
That’s another important IRS requirement: we’re talking about investment real estate here. So while individual investors are eligible, they can’t structure a 1031 exchange based on a desire to sell their primary residence or even a vacation home, and shield themselves from capital gains by investing the proceeds into a piece of investment property. Both properties in the exchange—the one being sold, and the one being acquired—need to be investment real estate. Section 1031 of the code makes it clear that properties held for use in a trade or business also qualify as investment properties for the purposes of an exchange.
A caveat: some folks have found a workaround in the case of second homes, or vacation homes, by transforming them into investment properties by renting them out for a period of time before selling them. A 2007 Tax Court case determined that properties held for personal use, even with the hope or expectation of capital gains, did not qualify as investments if the investor used them exclusively for their own use, or for the use of family or friends. A subsequent 2008 revenue procedure clarified that real properties qualified for 1031 exchanges if they were held by the investor for at least 24 months prior to (or subsequent to) the exchange, and for each of the two 12-month periods, they were rented at fair market value for at least 14 days, while restricting personal use to 14 days OR 10% of the number of days it was rented at fair market value, whichever was greater.
Requirement #3: The property being sold, or relinquished, must be an appreciated piece of real estate.
Finally, since the goal of a 1031 exchange is the deferral of capital gains tax by the investor, it stands to reason that the property being sold, or relinquished, must be an appreciated piece of real estate. As such, under ordinary circumstances, its sale would generally trigger a capital gains tax. If you’re somehow holding a piece of investment real estate whose sale would post a loss instead of a gain, there’s no need to consider a 1031 exchange, or any other investment technique designed at minimizing taxes. That’s the sole upside of a bad real estate investment: the tax man has no interest in your transaction!
Requirement #4: You must reinvest the proceeds into a like-kind exchange.
Assuming your real estate investment follows the pattern of the lion’s share of such transactions, and is subject to capital gains tax upon sale, the final requirement is your willingness as an investor to reinvest the proceeds into a like-kind exchange. In other words, you must sell your piece of investment real estate and subsequently buy another, usually more valuable, piece of real property that will also be an investment property.
Requirement #5: You must avoid a common pitfall to keep the tax man away.
If not properly structured, only a portion of a 1031 exchange might qualify for the deferral or elimination of capital gains taxes. Sometimes the replacement property is valued at a lower price than the relinquished property; the resulting difference between the two prices, known as boot, would present the investor with a tax bill based on the amount of the difference. (Learn more about Boot in Lesson 1 of Master the 1031 Exchange.)
Another common example of boot occurs when there is an unpaid mortgage on the relinquished property, but not on the replacement property. IRS regulations consider any debt the investor is relieved of as a result of the transaction to be money received. So if the investor sells the relinquished property and pays off mortgage debt with sale proceeds, the IRS would likely see this as a taxable gain to the investor and tax it accordingly. The easiest way to avoid mortgage boot is to encumber the replacement property with the same amount of debt as the relinquished property had on it.
There are other ways in which 1031 exchanges may result in boot, and several options to mitigate the situation, all of which merit a full discussion in a future chapter. For now, it’s enough to take note that actually paying the tax bill in question is a last resort, and one that can usually be avoided.
Requirement #6: You must follow strict timelines.
Ultimately, if you are ready, willing, and able to follow the timelines and other requirements proscribed by Section 1031 of the Internal Revenue Code, both your sale and your subsequent purchase will qualify for the preferential tax treatment of your resulting capital gains. We’ll examine these timelines and requirements in great detail in subsequent chapters of this guide, as we do in our 1031 Exchange Masterclass.
Understanding Delayed 1031 Exchanges
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:
1. The sale of the appreciated property, and the treatment of the proceeds
When the original property is sold, it is imperative that the investor does not take receipt of the funds generated by the sale. Instead, they are sent directly from escrow to a pre-selected independent third party, known as the qualified intermediary (QI) or the 1031 exchange facilitator. These professionals know to place the funds in an independent, FDIC-insured account, taking care not to commingle these funds with those of any other investors. The funds remain in this account until they are needed for the purchase of the replacement property.
2. The selection of the replacement property
As soon as the proceeds from the original sale are placed with an intermediary, two important clocks start ticking: the 45-day window during which a replacement property (or properties) must be identified and the 180-day window during which the second transaction must be closed. In the initial 45 days, the investor must identify at least one property or as many as the 200% rule would allow that will replace the relinquished property. Ideally, the property or properties in question will be equal to or greater in value than the relinquished property. (The investor can also choose a property of lesser value and commit additional funds to capital improvements; those funds will be counted towards the final net worth of the replacement property.)
Either way, the investor must identify the replacement property to the intermediary within 45 days of the closing of the first transaction; failure to do so invalidates the 1031 exchange. As far as replacement property ID rules there is the 3 property rule, the 95% rule, and the 200% rule which we discuss in more detail in our 1031 Exchange Masterclass taught by Daniel Goodwin.
3. Closing the deal on the replacement property
The investor has only 180 days to close the transaction for the replacement property. Accordingly, it’s usually considered best not to be overly communicative that the replacement property being sought is part of a 1031 exchange until a price is agreed upon; the owner of the replacement property would immediately understand that the investor is under a deadline, which translates into leverage for the seller and increased pressure for the buyer. Nevertheless, it is critical that not only is the price agreed to, but the entire transaction is closed within 180 days of the sale of the relinquished property. As with the sale of the relinquished property, it must be noted in the paperwork that the purchase of the replacement property is part of a 1031 exchange.
The importance of the 45- and 180-day deadlines in a 1031 exchange cannot be overstated. The IRS is inflexible, offering adjustments to these timelines only in the event of a Presidentially declared disaster or state of emergency. Failure to achieve the necessary steps within these windows, or improperly processing the 1031 exchange, potentially invalidates the entire exchange. Such an invalidation would subject the investor to significant taxes, possibly including the treatment of the transaction as ordinary income instead of capital gains; as ordinary income tax rates are significantly higher than capital gains tax rates, the resulting penalty could be severe.
However, with a carefully constructed transaction, and the efforts of a professional QI or exchange facilitator, a 1031 exchange can pay you handsome dividends, and defer capital gains taxes, for years and years to follow. Choosing a qualified intermediary is a critical step for the investor, as a capable, experienced QI will facilitate the transaction and ensure that the process is seamless for the investor.
