A 1031 Exchange offers real estate investors one of the last great investment opportunities to build wealth and save taxes. By completing an exchange, the investor (Exchanger) can dispose of investment property, defer the capital gain tax that would ordinarily be paid, and leverage all of his equity into the replacement property.
Investors can accomplish virtually any investment objective with exchanges including greater leverage, diversification, freedom from joint ownership, improved cash flow, geographic relocation and property consolidation.
IRS Code sec. 1.1031, as amended
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment purposes if such property is exchanged solely for property of a like-kind which is to be held for either productive use in trade or business or for investment purposes.”
In order to defer the capital gains tax, these basic requirements must be met:
- The Exchanger must acquire like-kind replacement property.
- The Exchanger cannot receive cash or other benefits tax-deferred.
- The exchange must be completed within strict time limits.
How does it work?
A typical tax deferred exchange is very similar to a taxable transaction except that
- prior to closing on the property being sold a qualified intermediary is assigned into the sale contract.
- They sell the property to the buyer and transfer the proceeds into a separate exchange account.
- The exchange is completed when the qualified intermediary is assigned into the Purchase Contract, utilizes the proceeds received to acquire the replacement property, and instructs the closer to transfer ownership to the exchanger via direct deeding.
Details of the 1031 Exchange
- Purchase Equal or Greater Value. The replacement property value must be the same as or greater than the value of the relinquished property.
- Reinvest all Net Equity. All of the equity realized in the sale of the relinquished property must be transferred into the replacement property.
- Additional proceeds or debt. If desired, the Exchanger may add additional proceeds to the new purchase or take on additional debt.
- No cash to the Exchanger. The exchanger cannot be in actual or constructive receipt of funds at any time during the exchange. Any constructive receipt would trigger a taxable event on those monies received.
- Equal or greater debt. The debt on the replacement property must be the same as or greater than the debt on the relinquished property. There is one exception to this rule:
- Exception to debt rule: A reduction in debt can be offset with additional cash from the Exchanger; however a reduction in equity cannot be offset by increasing debt. That is, the increase in debt cannot exceed the increase in value.
- Exchanges must be completed within strict time limits with absolutely no extensions.
- Property Identification Time Limit. The Exchanger has 45 days from the date the relinquished property closes to identify potential replacement properties. This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement properties. After the 45 days has passed, the Exchanger may not change their Property Identification list.
- Purchase Time Limit. The purchase of the replacement property must be completed within 180 days after of the close of the relinquished property. The property must be one of the listed replacement properties or the exchange fails.
- “Like-Kind” Property Test. The exchanger must sell property that is held for income or investment purposes and acquire replacement property that will be held for income or investment purposes. 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.
- Partial Exchange (“Boot”). 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.”
- Use of a Qualified Intermediary (QI). The QI is an independent third 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.