Introduction to 1031 Exchanges
What is a Tax-Deferred Like-Kind Exchange You Ask?
This subject certainly won’t get your adrenaline pumping unless you are facing a large income tax liability from the sale of rental, investment or business use property. If you are like many investors who avoid selling rental or investment property simply because they don’t want to pay income taxes, you may now be on the road to increasing your net rental income (cash flow) and your net worth by trading up into larger rental or investment properties while deferring your capital gain and depreciation recapture income tax liabilities.
Although the information provided in this article should never replace obtaining competent advice from your legal, tax and financial advisors, it will help you understand the basics of a tax-deferred like-kind exchange.
Advantages of a Tax-Deferred Like-Kind Exchange
A tax-deferred like-kind exchange allows you to sell rental or investment property (relinquished property) and purchase more profitable and/or productive rental or investment property (like-kind replacement property) while deferring Federal, and in most cases state, capital gain and depreciation recapture income tax liabilities.
This transaction is usually referred to as a 1031 Exchange but is also known as a delayed exchange, deferred exchange, starker exchange, and like-kind exchange. Technically speaking, it is a tax-deferred, like-kind exchange pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Department of the Treasury Regulations. I will refer to it as a 1031 Exchange going forward.
Full or Partial Tax Deferral
You must meet certain requirements in order to defer 100% of your Federal, and in most cases state, capital gain and depreciation recapture income tax liabilities on the sale of your investment property. Generally, for full tax deferral, you must (1) acquire like-kind replacement property that is equal to or greater in value than the relinquished property sold (based on net sales price, not based on your equity); (2) must reinvest all of the net proceeds or cash (net equity) generated from the sale of the relinquished property; and, (3) must replace the amount of old debt that was paid off on the disposition of the relinquished property with new debt of an equal amount on the like-kind replacement property.
You can always infuse more cash into the 1031 Exchange transaction but you cannot pull any cash out of the 1031 Exchange without recognizing depreciation recapture and/or capital gain income taxes. For example, if you acquired property with a $60,000 cash down payment and you are now selling the property and are completing a 1031 Exchange transaction, even the $60,000 initial cash investment must be reinvested in like-kind replacement property in order to defer 100% of your capital gain and depreciation recapture income tax liabilities.
The only way you can safely pull any cash out of your property without incurring a depreciation recapture and/or capital gain income tax liability is to refinance the property well before your 1031 Exchange transaction starts or after you have completed your 1031 Exchange by acquiring all of your like-kind replacement properties.
You can also purposely use the 1031 Exchange to defer only a portion of your depreciation recapture and/or capital gain income tax liability. This strategy is generally used when you have other income tax losses than can be used to offset some of your depreciation recapture and/or capital gain income tax liabilities.
Trading down in value and/or pulling cash out of your 1031 Exchange will result in the partial recognition of your depreciation recapture and/or capital gain income tax liabilities. The amount that is not exchanged for qualified like-kind replacement property is called cash boot or mortgage boot and will generate the recognition of your depreciation recapture and/or capital gain income tax liabilities.
It is extremely important that you consult with an experienced Qualified Intermediary (also referred to in the real estate industry as a 1031 Exchange Accommodator or 1031 Exchange Facilitator) and competent legal, tax and financial advisors for guidance in structuring your 1031 Exchange transaction. There may be other income tax issues not related to your 1031 Exchange that would affect your decision to structure your transaction as a 1031 Exchange.
1031 Exchange Structures
The most common 1031 Exchange structure is a Forward, or Delayed, 1031 Exchange where you sell your qualified relinquished property first and then acquire your like-kind replacement property either on the same day or at a later date. Closing both transactions on the same day is referred to as a Simultaneous or Concurrent 1031 Exchange. Closing the sale transaction first and closing the purchase transaction later is referred to as a delayed 1031 Exchange.
The opposite 1031 Exchange structure is referred to as a Reverse 1031 Exchange where you acquire your like-kind replacement property first and subsequently sell your relinquished property at a later date. Reverse 1031 Exchange transactions are much more complex than Forward 1031 Exchanges.
This article is intended to primarily provide concise and brief introductory information on Forward 1031 Exchanges. For more complete information on reverse 1031 Exchanges, please refer to our article titled "Introduction to Reverse 1031 Exchanges and Revenue Procedure 2000-37."
Although not discussed further in this article, you should also know that both Forward and Reverse 1031 Exchanges can typically be structured in conjunction with an Improvement (Build-To-Suit or Construction) component where the like-kind replacement property is improved, built, constructed or retrofitted as part of the 1031 Exchange transaction.
You can read our web page entitled "Forward, Reverse and Improvement 1031 Exchange Structures" for a complete summary of the various 1031 Exchange structures available.
The Qualified Intermediary (Accommodator or Facilitator)
The Qualified Intermediary often referred to in the real estate industry as the 1031 Exchange Accommodator or 1031 Exchange Facilitator, is the central component in a 1031 Exchange.
You select your own Qualified Intermediary. Your Qualified Intermediary is responsible for drafting the 1031 Exchange agreements and related documents in order to properly structure your 1031 Exchange transaction. You must assign your Qualified Intermediary into the Purchase and Sale Agreement and any related transactional documentation (such as Escrow Instructions) for the sale of each relinquished property and the purchase of each like-kind replacement property. The Qualified Intermediary will hold and safeguard your 1031 Exchange funds during your 1031 Exchange process.
Because of the Qualified Intermediary’s critical role and responsibilities throughout your 1031 Exchange transaction, you should review the tips outlined later in this article to assist you in the careful evaluation and selection of your Qualified Intermediary. You can learn more about the Qualified Intermediary by reading our articles entitled "The Role of the 1031 Exchange Qualified Intermediary" and "Choosing a SAFE 1031 Exchange Qualified Intermediary."
Basic Rules and Requirements
Qualified Use Property
You must have held your relinquished property for rental, investment or use in your business. And, you must have the intent to hold your like-kind replacement property for rental, investment or use in his business.
Property not held for rental, investment or use in your trade or business is not considered to be qualified use property and will not qualify for tax-deferred exchange treatment. For example, property acquired by you with the intent to fix-up and then sell ("flipping") is actually property held for sale and not held for investment and will therefore not qualify for tax-deferred exchange treatment. Likewise, apartments acquired for the sole purpose of converting into condominiums and then selling are actually held for sale and not held for investment and will technically not qualify for tax-deferred exchange treatment either. For more complete information on 1031 Exchange property holding requirements, please refer to our article titled "Holding Requirements for 1031 Exchange Properties."
Like Kind Property
Your relinquished and replacement properties must be like-kind in order to qualify for tax-deferred exchange treatment. In regards to real estate, any type of real property is like-kind to any other type of real property, as long as the qualified use test referenced above has been met (i.e. all of the properties are held for rental, investment or use in a trade or business).
There is a lot of incorrect information in circulation today stating that if you sell an apartment building you must acquire an apartment building, or if you sell a condo you must acquire a condo, for example. This is absolutely not true. You can sell vacant land and acquire commercial or industrial property. You could sell an apartment complex and purchase an office building or sell a retail center and acquire single family residential property. The key is that all of the properties must be held for investment.
In addition to real property, personal property can qualify for 1031 Exchange treatment if it meets the qualified use test and like-kind property tests for personal property. You must exchange personal property for like-kind personal property. You cannot exchange personal property for real property. Since the definition of “like-kind” is much more restrictive for personal property than for real property, a Qualified Intermediary experienced in 1031 Exchanges involving personal property such as Exeter 1031 Exchange Services, LLC should be consulted immediately if personal property may be involved with your 1031 Exchange transaction.
The like-kind replacement property must be acquired by the same taxpaying entity that sold the relinquished property. There are some exceptions to this rule that are not discussed in this article. You should consult with an experienced institutional Qualified Intermediary such as Exeter 1031 Exchange Services, LLC for further information and clarification.
Multiple Properties and Fractional Interests
You can sell multiple properties and/or acquire multiple properties. Your 1031 Exchange does not have to be one relinquished property and one like-kind replacement property. For example, a house may be exchanged for two condominiums or vice versa. The relinquished and/or replacement property can also involve a fractional or partial interest in the property. In other words, you do not have to sell, acquire and/or own 100% of the property.
1031 Exchange Requirement
You must ensure that your transaction is structured as a 1031 Exchange and not a sale and subsequent purchase. Also, both the relinquished and replacement property transactions must be part of an integrated transaction. An experienced institutional Qualified Intermediary such as Exeter 1031 Exchange Services, LLC can assist you with this process to ensure compliance with all applicable codes, regulations and rulings.
The replacement property identification process is the step where you must identify your potential like-kind replacement properties that are being considered for acquisition. This is only an identification requirement and the properties do not need to be under contract or in escrow. The potential like-kind replacement properties must be identified by the specific property address, assessors parcel number and/or legal description to the Qualified Intermediary, including a percentage if you intend to acquire a fraction or partial interest in the property.
To qualify for a 1031 Exchange, the identification process requires you to comply with only one (not all) of the following three identification requirements. (Refer to Time Deadlines referenced below for information on the deadlines regarding identification of potential like-kind replacement properties).
1) The Three (3) Property Rule:
The three (3) property identification rule allows you to identify up to, but not more than, three (3) potential like-kind replacement properties. In the event that you need to identify more than three (3) potential like-kind replacement properties you would ignore the three (3) property rule and look exclusively to the 200% of FMV rule, which is described next.
With the three (3) property rule, there is no limitation on the market value of the identified like-kind replacement properties. The limitation is only on the total number of like-kind replacement properties you can identify. Although you could do so, you are certainly not required to acquire all of the like-kind replacement properties identified. The three (3) property rule allows you to identify more than one property so that you have back up replacement properties identified in case the first choice cannot be acquired. This is the most common and the easiest of the like-kind replacement property identification rules to work with.
2) The 200% of Fair Market Value Rule:
Unlike the three (3) property rule, the 200% of FMV rule allows you to identify more than three (3) potential like-kind replacement properties as long as the total fair market value of all the identified properties does not exceed 200% of the sales price of your relinquished property(ies).
The limitation is only on the total fair market value of the replacement properties identified. For example, if you sold relinquished property valued at $2,000,000 you would be able to identify as many replacement properties as you want provided that the total fair market value of all of the identified replacement properties combined did not exceed $4,000,000.
3) The 95% Exception Rule:
In the event you must identify like-kind replacement properties that exceed the three (3) property rule and the 200% of FMV rule, your identification will still be considered valid for 1031 Exchange treatment if you acquire at least 95% of the fair market value of the replacement properties that were identified.
1031 Exchanges are subject to very specific time restrictions or deadlines that cannot be extended, waived or altered for any reason unless the President of the United States grants an extension of time due to a natural disaster.
45 Calendar Day Identification Period
You have 45 calendar days from the close of your relinquished property sale transaction (and the conveyance or transfer of legal title to your relinquished property) to identify potential like-kind replacement property(ies) to be acquired.
The deadline is not extended if the deadline falls on a Saturday, Sunday or legal holiday, so you must ensure that your identification is received by the Qualified Intermediary no later than midnight of the 45th calendar day.
You can change and revoke your identification as often as you wish during the 45 calendar days by revoking any prior identifications made and submitting a new identification to the Qualified Intermediary. The identification can not be changed or altered after the 45 calendar day deadline has passed.
180 Calendar Day Exchange Period
You must complete the acquisition of one or more of your identified like-kind replacement property(ies) no later than the earlier of (1) 180 calendar days from the close of your relinquished property sale transaction, OR (2) by the due date, including extensions, of your Federal income tax return for the year in which the relinquished property was sold.
In other words, if your relinquished property sale transaction closes before October 17th of any given tax year, you must close on the acquisition of your like-kind replacement property no later than the 180 calendar day period.
However, if your relinquished property sale transaction closes on or after October 17th, but on or before December 31st, of any given tax year, the 180 calendar day period ends after April 15th, which is the deadline to file your Federal income tax return if you are an individual filer. You must file for an extension of time to file your Federal income tax return so that you will have the full and complete 180 calendar days to complete your 1031 Exchange transaction.
Actual or Constructive Receipt
You are not allowed to have any actual or constructive receipt of your 1031 Exchange funds during the 1031 Exchange period. Actual or constructive receipt occurs at the time you have actual possession of the funds, exercise control over the funds, or you receive any economic benefit from the funds or assets. Actual or constructive receipt of any portion of the 1031 Exchange funds or assets during the 1031 Exchange period will result in a taxable event and may result in the complete disallowance of your 1031 Exchange transaction.
Your Qualified Intermediary must be assigned into the purchase and sale agreements (and escrow instructions if applicable) of the relinquished property and the replacement property before either transaction closes and/or the properties are transferred to the respective buyers in order to avoid constructive or actual receipt of your 1031 Exchange funds. If either transaction should close before the Qualified Intermediary has been assigned into the transaction, the transaction will fail to qualify as a 1031 Exchange.
Selecting a SAFE Qualified Intermediary (Accommodator or Facilitator)
Since the Qualified Intermediary will be holding your funds during the 1031 Exchange transaction, you should carefully evaluate and select the Qualified Intermediary that you choose to administer your 1031 Exchange transaction.
There are four (4) primary risks that you should be cognizant of when researching, evaluating and choosing your Qualified Intermediary. They are (1) depth of experience and expertise; and (2) employee error or omission; (3) employee theft or embezzlement of funds; and (4) a bankruptcy filing by the Qualified Intermediary.
Professional, experienced, institutional Qualified Intermediaries such as Exeter 1031 Exchange Services, LLC will understand your concerns. They will have analyzed and addressed these concerns and will have already implemented appropriate policy, procedures and safeguards to protect your 1031 Exchange funds.
When evaluating 1031 Exchange Qualified Intermediaries, you should ask about the following:
Does the Qualified Intermediary have sufficient depth of experience and expertise to administer your 1031 Exchange transaction?
Has the present ownership and management of the Qualified Intermediary been constant and consistent for quite sometime, or has there been any changes in ownership or management that might be of concern?
Does the Qualified Intermediary ("Accommodator" or "Facilitator") maintain sufficient fidelity bond coverage to insure against employee theft or embezzlement of the 1031 Exchange funds?
Is the fidelity bond coverage "per occurrence" or merely "in aggregate"?
Does the 1031 Exchange Qualified Intermediary ("Accommodator" or "Facilitator") maintain sufficient errors and omissions insurance coverage to insure against any error or omission that creates a loss for you?
Does the fidelity bond and errors and omissions insurance policies cover just the Qualified Intermediary (“Accommodator” or “Facilitator”) operation/company, or does it also cover related entity operations, such as title insurance operations, escrow operations or other operations, that might diminish the overall coverage and protection to you in the event of multiple losses through the consolidated entity?
Does the Qualified Intermediary (“Accommodator” or “Facilitator”) have significant experience and expertise to ensure your transaction is administered within the prescribed regulations?
Does the Qualified Intermediary use either Qualified Trust Accounts or Qualified Escrow Accounts to hold and safeguard your 1031 Exchange proceeds?
You should request copies of the Qualified Intermediary’s insurance binders and contact their insurance agent to verify the coverage as part of your due diligence in order to verify the answers to the above questions.
Want to Know More?
This article is meant to be a brief and concise overview of 1031 Exchanges. You can obtain more detailed, in depth and technical information by downloading A Guide to 1031 Exchanges© or our Section 1031 Tax Deferred Exchange Reference Manual©.
The 1031 Exchange Advisors and Consultants at Exeter 1031 Exchange Services, LLC are always available to assist you with the planning and structuring of your 1031 Exchange transaction as well. You can reach them 24 hours a day, 7 days a week, 365 days a year. You should always consult with your own legal, financial and tax advisors before attempting to structure or complete a 1031 Exchange transaction.
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