Is a 1031 Real Estate Exchange Right for You?
- 1031 exchanges allow you to defer paying capital gains taxes on the proceeds of a sale of investment real estate by purchasing another similar property.
- While they can be useful, the details of 1031 exchanges are complex, and missteps can be costly. Working with real estate professionals skilled in this area is critical.
- In this A Closer Look, we review the details of 1031 exchanges and how to meet the criteria to use one successfully.
If you are a real estate investor or property owner, chances are you’ve heard about the 1031 exchange. Introduced as part of the Revenue Act of 1921 to provide taxpayer relief and encourage real estate investment, it was later included as Section 1031 of the first Internal Revenue Code in 1939. The provision allows you to defer payment of capital gains taxes due on the sale of a real estate property if you purchase another similar property in its place. The specific requirements and limitations have changed several times over the decades, but the principal benefit of a 1031 exchange — the postponement of capital gains taxes — remains intact.
While these like-kind property exchanges can clearly be a useful tax planning opportunity, the rules governing them are complex and challenging. Only certain types of real estate qualify, strict timelines must be followed, qualified intermediaries must be engaged, and failure to meet these and their many other requirements can cause an exchange to fail.
If you’re contemplating a 1031 exchange, it’s important to understand what’s involved and work with an experienced real estate advisor who specializes in this area.
In this A Closer Look, we review 1031 exchanges — what they are, how they work, their potential benefits, and some of the complex issues involved in using them successfully.
What They Are
Under Internal Revenue Code Section 1031, an investor/owner can exchange one business-use or investment property for another like-kind business-use or investment property. In successful exchanges, the payment to the IRS of any taxes due on capital gains may be deferred — although not indefinitely.
These exchanges must be brokered by a qualified intermediary (sometimes called an exchange accommodator), usually an individual financial professional or a company with appropriate expertise. The qualified intermediary is responsible for a variety of functions. These typically include compiling appropriate paperwork and directing funds into a qualified escrow account. Once the exchange is successfully completed, the qualified intermediary ensures the release of funds to the appropriate parties. (For guidance on choosing a qualified intermediary, see “Diligence When Choosing an Intermediary” below.)
Diligence When Choosing an Intermediary
The IRS recommends diligence in choosing a qualified intermediary as there have been incidents of intermediaries declaring bankruptcy and being unable to meet their contractual obligations to the taxpayer. This has resulted in taxpayers being unable to meet the strict timelines (45 days and 180 days) set for a 1031 exchange. This usually disqualifies the transaction from deferral of gain, with taxes due to be paid in the tax year in which the transaction was supposed to take place.
There are two strict deadlines with any 1031 exchange, and they both begin once a sale is finalized. After the sale, you have 45 days to identify a property (or properties) you’d consider buying and 180 days to complete the purchase. Failure to abide by these deadlines may result in taxes on the sale becoming due in the same taxable year the sale was made.
Why You Might Consider One
What makes 1031 exchanges potentially useful is that they may allow you to defer the payment of any capital gains tax normally due from a sale. Some investors may wait until they are in a lower tax bracket before paying capital gains taxes due upon a sale. In a typical real estate transaction, investors may have to pay 25 percent or more of any taxable gain to the IRS, as well as pay state income or capital gains tax. With a successful 1031 exchange, instead of that cash going to the IRS or state coffers when you next pay your taxes, you might be able to use it to:
- Manage the timing of capital gain recognition.
- Diversify your real estate holdings more efficiently.
- Readjust your investments to better align with your long-term goals.
- Buy a property with better cash flow or future prospects for appreciation than the one you have now.
Exchanges and Depreciation
The acquisition of a new property typically starts the depreciation process on that property. The IRS rules on exchange depreciation are intricate, and it’s important to understand the various steps involved. Here are two of the main steps.
Step One: Identify the cost basis of the replacement property, which comprises the adjusted cost basis of the relinquished property (cost basis less accumulated depreciation), plus any additional funds used to purchase a replacement property (if applicable). You can see how this works in “Cost Basis and Depreciation: An Example” below.
Step Two: After you’ve completed a successful 1031 exchange, you must choose one of the two methods of depreciation permitted by the IRS. Let’s walk through them using the figures from our example below.
- Commonly used method: Split the depreciation into two separate schedules, where you continue depreciating the relinquished property with an adjusted cost basis of $127,000 for the remaining 17.5 years, and the cost basis for the replacement property of $25,000 will depreciate for 27.5 years.
- Alternative method: You may opt out and take a simplified single schedule depreciation on the adjusted cost basis of the replacement property of $152,000 for 27.5 years. This method may result in a smaller deduction than the commonly used method above.
Cost Basis and Depreciation: An Example
An investor purchases a single-family rental home for $200,000 and sells it 10 years later for $275,000.
During this time, the investor has taken depreciation of $73,000 (rounded up), for an adjusted cost basis of $127,000.
The amount subject to tax is the depreciation of $73,000 plus the gain of $75,000, for a total of $148,000. This is the amount that may be deferred through a 1031 exchange.
If the investor purchases a replacement property for $300,000, the new adjusted cost basis will be $152,000, the sum of the adjusted cost basis from the relinquished property of $127,000 plus $25,000 in additional funds used to purchase the replacement property.
Value of Replacement Property
To qualify for full deferral of taxes on gains made during a 1031 exchange, you must buy a replacement property (or properties) that has the same value as, or a greater value than, the property you plan to relinquish. Here are some important points to consider:
- To qualify for complete gain deferral, all sale proceeds from the relinquished property must be reinvested into the replacement property.
- Any portion you choose not to reinvest — often called “the boot” — is taxable.
- If the replacement property is of greater value than the relinquished property, you are permitted to add cash or additional debt to the exchange.
- If the replacement property is of lesser value, you will typically owe taxes on the difference in values. Here’s a quick example: You sell a single-family rental home for $325,000 and plan to defer taxes through a 1031 exchange. But the replacement property you buy costs only $250,000 — the $75,000 difference can be taxed.
The benefits of a successful 1031 exchange can be significant; however, certain considerations need to be addressed to ensure a successful outcome. Here are some of them:
- 1031 exchanges must be like-kind exchanges. The real estate you wish to sell must be exchanged for another piece of real estate. That said, there is flexibility in what like-kind means. If you wish to sell, say, an apartment building, you can certainly purchase another apartment building, but you can instead buy a piece of vacant land, a warehouse, a shopping mall, or another property type. All shares in a single-member LLC that holds real property is another example of like-kind property. The purchase of a tenant-in-common interest in a property or shares in a Delaware statutory trust may also qualify for 1031 treatment.
- 1031 exchanges can occur only if the real estate involved is an investment property or used for a trade or business. They cannot be used on a sale of a primary or secondary residence, vacation home, or similar property, unless strict rules are met wherein the residence is used solely for rental purposes for a specified period prior to the sale.
- Certain types of (non-real estate) property do not qualify for Section 1031 treatment. Effective January 1, 2018, certain items that might be stored in a relinquished property do not qualify for like-kind exchanges. They may include machinery, vehicles, artworks, and collectibles. The same is true for related patents, intellectual property, and other intangible assets. Any gain made from the sale of items in these categories may be taxable.
- Only U.S. properties qualify. Any property held outside the U.S. is ineligible for 1031 treatment.
- Acquiring and selling entities must be the same. The entity that acquires the replacement property must be the same entity that sells the relinquished property. There are some exceptions with respect to certain kinds of trusts and other limited situations, but any variation in entities must be carefully vetted by a tax professional.
- Debt must be replaced. If the relinquished property has debt on it, that debt must be replaced in connection with acquisition of the replacement property. There are a variety of ways to do this, including new debt or additional cash investment. Failure to replace the debt on the relinquished property can result in a taxable gain in the amount of the debt.
- Refinancing can be an issue. Care must be taken in any potential refinance before the sale of the relinquished property or after the acquisition of the replacement property. The IRS could construe that refinance as a tax avoidance mechanism and deem the refinance proceeds taxable.
Once you sell a property that you identified for 1031 treatment, you’ll need to meet two deadlines that run concurrently:
Deadline one: 45 days after sale. With the first deadline, you have 45 calendar days to identify, in writing, potential replacement properties, sign the document, and deliver it to a person involved in the exchange, such as the seller of the replacement property or a qualified intermediary. Presenting this documentation to your attorney, real estate agent, or accountant, rather than to the seller or qualified intermediary, may disqualify the sale for the 1031 tax deferment.
There are specific rules regarding the number of properties that may be designated and/or the total value of the designated properties. Care must be taken to follow these rules or risk invalidating the exchange.
Deadline two: 180 days after sale. With the second deadline, you have 180 calendar days to purchase a replacement property or properties. (See also “Reverse Exchanges” below.)
You should make every effort to meet these deadlines:
- If you do not complete the required steps before the two deadlines, you may have to pay taxes on any gain in the tax year the transaction was scheduled to be completed.
- If you are approaching the purchase deadline, the pressure to buy may lead to poor decision making. The probability of overpaying for a property increases, as does the likelihood of overlooking deficiencies in the replacement property, which may become costly problems in the future.
- These deadlines cannot be extended for any circumstance or hardship, according to the IRS, with one exception: in the case of presidentially declared disasters.
To help you meet these deadlines, consider identifying several properties that fit your purchase criteria before (or very soon after) you sell a current property.
Cash and Exchanges
Cash proceeds from the sale of a property in which the seller contemplates completing a 1031 exchange must be directed by the qualified intermediary into a qualified escrow account. The seller cannot have any access to the sale proceeds or the 1031 will be invalidated. The qualified intermediary will deliver funds directly to the appropriate party at the successful completion of the exchange.
One additional point: If the seller receives cash from the sale of any items that might be stored in a replacement property — artworks, machinery, automobiles, and the like — it will be subject to capital gains tax.
The IRS permits investors to invert the standard 1031 exchange sequence. In what’s referred to as a reverse exchange, rather than sell a property first and then buy a property, investors can acquire a replacement property first and then sell a current property. Here are some important points about reverse exchanges.
- By buying first and selling later, investors may be able to hold onto a property that they believe may increase in market value in the interim, potentially giving them more time to sell for maximum profit.
- The potential buyer must have the financial capability to buy a property even though the current property has not yet been sold.
- A reverse exchange must involve a qualified intermediary or facilitator.
- Like a standard 1031 exchange, the reverse exchange also has two deadlines, 45 days and 180 days, but the order is switched: Both start at the time of purchase rather than the time of the sale. In the first deadline, you have 45 days to identify the property you wish to sell. In the second, you have 180 days to complete the transaction.
To avoid rushing to meet a deadline, you should seek to identify a property you wish to sell well before (or soon after) you purchase a property and the time limit for meeting the deadline starts running.
Reporting Section 1031 Exchanges to the IRS
You must report a 1031 exchange to the IRS on Form 8824, Like-Kind Exchanges, and file it with your tax return for the year in which the exchange occurred. The form will ask for descriptions of properties exchanged, including:
- Dates that properties were identified and transferred.
- Any relationship between the parties to the exchange.
- The value of the like-kind and other property received.
- Any gain or loss on sale of other property given up.
- Cash received or paid; liabilities relieved or assumed.
- Adjusted basis of any like-kind property given up; and any realized gain.
By following these and other rules for reporting like-kind exchanges, you should avoid being held liable for taxes, penalties, and interest on your transactions.
When successfully executed, the 1031 exchange is a valuable tool for real estate investors. However, the rules are complex and rigid, and proper planning and diligence are critical. It is also important not to let the pursuit of tax savings override sound real estate investment decisions.
If you’re interested in pursuing a 1031 exchange, Bessemer’s real estate advisory professionals are available to help you consider the potential risks and rewards and recommend qualified professionals, such as exchange accommodators and real estate brokers, to help execute an exchange.
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