Key Takeaways
- The IRS allows deferral of taxable gain on the sale of real property if it is exchanged with a property (or with properties) of “like-kind.”
- A “like-kind” property is a property that shares the same nature, character or class as the original property.
- Any individual, C-Corp, S-Corp, partnership (general or limited), LLC, trust or taxpaying entity can participate in a 1031 exchange.
- You have 45 days from the date of sale of the relinquished property to identify potential replacement properties.
- The exchange must be completed in full no later than 180 days after the sale of the original property or the due date (with extensions) of the tax return for the year in which you sold the original property, whichever is earlier.
What Is a 1031 Exchange?
A 1031 exchange is a transaction where a taxpayer sells real property held for investment or use in trade or business and uses the funds to purchase a replacement property of “like-kind” within a specific timeframe. It is essentially a tax break.
The IRS defines “like-kind” as properties that are “of the same nature or character, even if they differ in grade or quality.”
Typically, when you sell the original property, there is a gain or loss (difference between the purchase price and the sale price). This gain or loss has tax consequences. However, if you use a 1031 exchange, you can defer those tax consequences by rolling the gain into a new property.
For example, say you own a condo building that you purchased for $1,000,000. Five years later, you sell the building for $2,000,000. Usually, this $1,000,000 is taxed at long-term capital gains rates (likely 20% federally plus any state gains tax). However, if you utilize a 1031 exchange and use the $2,000,000 to purchase a Commercial Retail Center, that $1,000,000 is rolled into the new property, and you can defer the capital gains taxes (i.e., you won’t have to pay the taxes until a gain is realized).
Utilizing a 1031 exchange, although complex, can be beneficial for properties that have accumulated significant gains. The risks of incorrectly executing the 1031 exchange process are severe so employing real estate, tax and legal professionals to complete the transaction correctly will be essential.
What Qualifies?
There is the obvious; a residential rental property is like-kind to another residential rental property. Same with a commercial retail center for another commercial retail center.
However, the property types do not need to be identical. Generally speaking, any real estate property used for trade or business can be exchanged for any other real estate property used for trade or business under the 1031 exchange rules. Is farmland like-kind to commercial real estate? Yes. What about a condo building and vacant land for development? That’s like-kind too.
There are some limitations to “like-kind” property. As of January 1, 2018, machinery, equipment, vehicles, artwork, collectibles, patents or other intangible property do not qualify as like-kind exchanges. Also, properties inside the U.S. are not like-kind to properties outside the U.S. So, if you have a foreign real estate property and want to buy a property in the U.S., it would not qualify for a 1031 exchange.
When dealing with international properties and taxes, it is essential to note that it adds layers of complexity. We highly recommend speaking with an international tax expert in both your home country and the foreign country when buying and selling property so that you are following all applicable tax laws.
Section 1031 does not apply to exchanges of inventory, stocks or bonds, other securities or debt, partnership interests or certificates of trust.
When To Use a 1031 Exchange
A 1031 exchange is best used when you have a gain inside an investment or business property and want to replace it with a new property that provides more benefit to you without realizing the gain on the sale of the original property.
1035 Exchange Scenarios
- A manufacturing business owns its building but is running out of space, but they find a new larger facility that fits their needs and growth expectations.
- A residential condo building owner has an underperforming property. They want to offload this property and diversify their holdings with a commercial office building.
- An individual with one large vacation rental property wants to purchase three smaller properties in a more popular travel destination.
All three of these examples are quite different. A manufacturing company, a larger real estate company and an individual. However, the properties all share a common theme: they are used in investment, trade or business. Therefore, they are eligible for a 1031 exchange.
Notice in the last example there were multiple properties exchanged for one. You can buy multiple properties using a 1031 exchange, not just one-property-for-one-property.
How Do 1031 Exchanges Work?
1031 exchanges can be very complicated. If you make mistakes in the documentation or handling of the property or sales proceeds, you could end up with a hefty tax bill.
In a simple exchange of property between the taxpaying seller and the buyer (a two-party exchange), the 1031 process is easy. The parties transfer the property to each other, the attorneys and title companies ensure that the process goes smoothly, then the exchange is reported to the IRS.
However, if there are multiple parties (the seller (you), the buyer of your property and the seller of the identified property, for example), then having a Qualified Intermediary may be required. This can help ensure the process follows all rules and regulations so that no mistakes are made.
What is a Qualified Intermediary?
A Qualified Intermediary is a separate, non-related party that supports a taxpayer’s intent to initiate a 1031 exchange. Their primary role in the process is to educate the taxpayer and coordinate the documentation and communication with the title company and attorneys so that all 1031 rules are followed appropriately. They also ensure the closing statements show a 1031 exchange happened. Consider speaking with a qualified intermediary as early as possible in the process, well before you try to sell your property or buy a replacement.
Types of 1031 Exchanges
There are four main types of 1031 Exchanges: two-party simultaneous, delayed, reverse and contribution/improvement exchange. Each has its difficulties and associated risks.
Two-Party Simultaneous Exchange
The oldest of the four 1031 exchange types, a two-party simultaneous exchange is where two parties agree to swap deeds and ownership interests in their properties. There is no need to find buyers, and often no need for a Qualified Intermediary. However, finding properties where this exchange could work isn’t easy. Delays in the transfer of ownership can expose the owners to significant tax liabilities.
Delayed Exchange
Delayed exchanges are very common. The majority of 1031 exchanges are delayed exchanges. You first need to sell your existing property to enter into a delayed exchange. From there, you have 45 days to identify a like-kind replacement (or replacements), then the purchase must be completed within 180 days.
Reverse Exchange
Reverse exchanges are like delayed exchanges, with 45-day and 180-day deadlines. The main difference is that the first step is buying the replacement property instead of selling your existing property. From there, you have 45 days to identify a like-kind property you own to sell. The same 180-day deadline applies to complete the exchange. These are tricky in that you cannot possess both the replacement and relinquished property at the same time. So the use of Qualified Intermediaries and Special Purpose Entities is required to ensure all IRS rules and regulations are followed.
Construction/Improvement Exchange
The construction/improvement exchange adds another wrinkle to the 1031 exchange process. In that, an investor can use the gains from the exchange to make improvements to the target property. This could be refurbishments, renovations, capital improvements to existing properties or new ground-up builds on vacant land. Some caveats: the same 45-day and 180-day deadlines apply, so all improvements must be completed in that timeline.
1030 Exchange Rules and Requirements
It is important to understand the rules and requirements of a 1031 exchange. Property rules and regulations over the timeline of the process can make things complicated.
Property Rules
When dealing with multiple properties, the three property rule, the 200% rule and the 95% rule must be taken into consideration.
Three Property Rule
You can identify up to three properties of any value for replacement.
200% Rule
You can identify more than three properties, but the total value of the properties cannot exceed 200% of the relinquished property’s value. So, if you sold the original property for $1,000,000, the replacement properties’ combined value could not exceed $2,000,000. This works great for an investor wanting to buy many smaller properties.
95% Rule
Triggered by the 200% Rule, the 95% Rule allows you to identify more than three properties with combined values of over 200% — this would be $2,000,000 if using our example above. But only if you close 95% of the aggregate value of all the properties that have been identified. The 95% Rule sounds like a great option but is challenging to execute because of the difficulty of closing just about every property identified inside the 180-day timeline. If these rules are broken, the capital gains tax is owed.
Timeline
The IRS imposes strict and non-negotiable timing requirements on 1031 exchanges: the 45-day and 180-day rules. If you miss these deadlines, you will not receive the 1031 exchange tax treatment and will pay capital gains tax on any profit from the sale of your property.
45- and 180-day Rules
| 45-day Rule | 180-day Rule |
|---|---|
| You have 45 days to identify a like-kind replacement from the date of sale of your relinquished property. | You must close on the replacement property within 180 days from when you sold the relinquished property. |
| Identification must be in writing, signed by you and delivered to the seller or qualified intermediary. | So, when you sell your property, you have six months to close on the new property, or else you will owe capital gains tax on any profit. |
Any taxpayer can take advantage of a 1031 exchange: Individuals, C-Corps, S-Corps, Partnerships (general & limited) or LLCs can use a 1031 exchange.
Pros and Cons of 1035 Exchanges
While there are plenty of reasons to think that 1031 exchanges are attractive, that does not mean there are no downsides. Understand the pros and cons before making a decision about your property.
- Deferred Taxes
- Deferring the gain on the taxes prevents a large tax bill in the tax year of the sale.
- Larger Property
- The deferral of the taxes leaves you with more buying power to buy a larger property. This could be very beneficial for a growing business.
- Consolidation/Diversification
- Consolidating multiple properties down to one or diversifying a condo building into two commercial retail centers without tax consequences provides business owners and investors excellent flexibility.
- Cash Flow
- Exchanging a non-cash-flow-generating property for a cash-flow-generating property can be a significant boon for a business.
Pros
- Complexity
- The additional paperwork, legal requirements and finding a suitable like-kind property can be daunting and overwhelming.
- Timeline
- From the date of sale of the property you are relinquishing, you have 45 days to identify a replacement property. And 180 days from the date of sale to close on the replacement purchase. If you miss these deadlines, the tax benefits of a 1031 exchange disappear.
- Access to Capital
- To avoid paying the capital gains tax on the sale of your property, you have to roll all of the sales proceeds into the replacement, not just the gains. So there is a lack of liquidity in this strategy that may or may not be appropriate for investors or businesses who need access to those funds.
- Partner Disagreements
- If your business or investment has multiple partners, they may disagree on whether a 1031 exchange is worthwhile. Or some may want to take cash out in the event of a property sale. These complications of multiple owners/investors may involve creating separate entities or buying out partners, which adds additional stress to an already stressful situation.
Cons
Tax Implications of 1031 Exchanges
As with all significant financial transfers of assets, taxes play a crucial role. Thankfully, when done correctly, 1031 exchanges help to defer any capital gains on the sale of a new property.
One of the last steps of a 1031 exchange is reporting to the IRS using Form 8824. While it is a simple 2-page form, it is essential to ensure that any gains are deferred. Filling out the form is straightforward, with simple questions about the relinquished property, replacement property, associated dates of sale, identification and completion of exchange (for the 45- and 180-day rules). If you used one, there is also a section to include information on the Qualified Intermediary.
So, suppose you follow the IRS guidelines and exchange your property with a $500,000 gain with a like-kind property. In that case, you will defer any federal or state capital gains taxes on that $500,000 (depending on the state you live in, it could be as much as 40%, or $200,000 in this example, in federal and state taxes).
But if you cannot complete the transaction in the allotted time, have simultaneous possession of the relinquished and replacement property or forget to file the appropriate reporting form with the IRS, the exchange could be rejected, leaving you with a substantial tax liability.
Since 1031 exchanges are so complex and the tax consequences so severe, consider speaking with a tax professional and a 1031 exchange professional.
