Everything You Need to Know About 1031 Exchanges

1031exchanges.jpg

Thanks to IRC Section 1031, a properly structured 1031 exchanges allows a real estate investor to defer all their capital gains taxes upon the sale of a property, as long as they then purchase a like-kind replacement property.

This is an amazing tool to use as an investor, but it’s not without its rules and requirements, of which there are many. First and foremost, the property being sold and purchased must be used in a trade or business or held for investment. Let’s dive deeper into how these exchanges work.

The 1031 exchange aka “Like-Kind” exchange

To understand the benefit, you must first understand that capital gains tax is the taxable income from selling an asset for more than its basis (the adjusted cost). As mentioned above, the 1031 exchange allows one to defer paying capital gains tax as long as they are intending to acquire other similar properties within a relatively short period of time.

Here’s an example:

You purchase a home for $300,000. After holding it for many years, you go to sell it for $1,000,000. The capital gains would be calculated on the difference between the original purchase price and current sales price, which in this example is $700,000.

The amount of taxes you owe depends on your tax bracket. Per the Federal capital gains tax rules, it could be anywhere from 15-20% from the total gains. There are also capital gains taxes for the state of California, and the Medicare Tax of 3.8% - essentially an additional federal capital gains tax, applicable if your income is more than $200,000 or $250,000 for a married couple filing jointly.

As you can see, capital gains tax adds up very quickly.

In addition, there’s something called Depreciation recapture which would apply to those property owners who have taken a deduction for depreciation on their property. It is 25% of the total deductions claimed.

1031 Exchange Requirements

We’ll dive deeper into the details later on in this article, but here are the primary requirements:

  • The property you buy and the property you sell must be “like-kind”, meaning it must be equal or greater in value and equity

  • It must be used for a trade or business or used as an investment

  • You must identify the home within 45 days and close escrow within 180 days

  • “Same Taxpayer Rule” or “Vesting Rules” – the same taxpayer that sells the property, must be the same taxpayer that buys

Common Terminology

Here are some terms you should be familiar with:

  • Relinquished Property: the property you sell in the exchange

  • Replacement Property: the property you purchase in the exchange

  • Qualified Intermediary: the company that facilitates the exchange and holds the funds on your behalf

  • Boot: When you sell a property and buy a new property, but you keep a portion of the cash proceeds for yourself, that cash is referred to as “boot” and you will be taxed on the portion of the cash that you retain. Keeping that cash is not “like-kind” to real estate and therefore excluded from the 1031 exchange tax deferral.

Creating an Exchange

Many years ago, you used to only be able to do an exchange between 2 parties who wanted to swap. Over time, people began to be able to sell to one party and buy from another party, or perhaps the same party, but at a later date. The IRS came up with regulations to standardize this process where you can sell to one party, and buy from another, and do so at a later date, but have the transaction still considered an “exchange”.

The first step is finding a qualified intermediary, where you provide the Purchase Agreement for the property you are selling and a “title commitment” on the relinquished property. The QI will create documents to set up the exchange. All of this paperwork must be done prior to the closing of escrow on the sale of your relinquishment property.  

Another requirement is that the QI must hold the funds; the taxpayer cannot control the net proceeds from the sale of the relinquished property. The funds sit with the QI in an account with the taxpayer’s name on it, until they are instructed to send the funds to escrow to purchase the replacement property.

What is like-kind?

What you buy must be similar to what you sold! In real estate, “like-kind” is very broad. As long as it’s an investment property or property used in connection with your business, and its real estate, you can exchange it. If you sell a single-family home you rented out, you can buy vacant land. If you sell an apartment building, you can exchange it with a retail center.

What is not like-kind?

It must be an investment property (i.e. receiving rent) or a property used in your business. Property that is held for personal use, is not considered an investment property. This would include a primary residence or a vacation home (unless you use this second home primarily for rental income). There are other benefits when you go to sell your primary residence, however! See here for information on  Section 121.

There is a specific rule pertaining to vacation homes. They may be considered investment property and therefore exchangeable if you do not use it for yourself more than 14 days per year and you rent it out at least 14 days per year and you do that for a total of 2 years in a row.

Property that is held for sale is also not eligible for a 1031 exchange. This is a property that you intend to sell, but you do not intend to hold for long term gain or receiving of rent. For example, people who purchase a property and plan to flip it.

Another example would be a developer who builds homes and sells them. Their intent is not to hold those homes as an investment, their intent is to sell them.

There are also properties that have more than one purpose. For example, if you own a primary residence and also use a portion of that home for your personal business. You can actually do an exchange of that portion of your home; that is something you need to discuss with your tax consultant to come up with a dollar value attributable to that office space.

Properties that are not eligible for exchanges would be stocks, bonds, and partnership interest. Although a partnership can buy, own, and sell property, the actual partnership interest themselves are not exchangeable.

Time Limits

Once you close the escrow on the sale of your relinquished property, you will have 45 calendar days to identify the property you plan to purchase. This identification must be in writing and it must be clear, meaning you must specify the address. You must deliver the identification to anyone involved in the transaction, except for a disqualified party. Your real estate broker is a disqualified party. Most commonly, you deliver the written identification of the property you wish to purchase (the replacement property) to the exchange company.

There are also limits to how many properties you can identify. You can use the “3 Property Rule”, which states you can identify up to 3 properties regardless of their fair market value. That could mean you plan to purchase all 3 properties as a part of this exchange, or you only intend to purchase 1, but are listing the other 2 properties as “backups”.  Some people may identify backup properties because once you pass the 45-day period, you are not allowed to amend your identified properties list or identify any additional properties. If you fail to get into escrow on your top choice, you have 2 other identified properties that you can still use to qualify for a 1031 exchange.

A second identification method that works well is the 200% Rule, which works well for people who may want to buy a couple of replacement properties. This states you may identify as many properties as you wish as long as the total is not more than twice the fair market value of what you sold. For example, if you sold your relinquished property for $1,000,000 you could identify 10 different properties, as long as the total value of those homes doesn’t add up to more than $2,000,000.

Lastly, you may use the 95% Rule. This states you can identify as many properties as you’d like, regardless of their fair market value, as long as you end up closing on 95% of what you have identified during your exchange period.

It’s important to note that any property you purchase within the 45-day period is automatically deemed as property identified, and you don’t have to worry about the particular identification method.

These are the methods by which you identify your replacement property you wish to purchase within 45 days; however, there is yet another time limit in relation to 1031 exchanges. You only have 180 days to close escrow on the purchase of the identified property and the clock begins ticking after you sell your relinquished property. It gets a bit trickier… the rule actually states is that the deadline is the sooner of 180 days after the relinquished property sells, or the date your tax return is due. For instance, if you sell your property late in the year (December 25th) and you need to file your property taxes by April 15th, you’d have to request an extension to file your taxes to get the full benefit of the 180 days.

There are no extensions on these timelines – even if it falls on a Saturday, Sunday, or a legal holiday. So, let’s review…Day 0 is the date that the sale of your relinquished property closes escrow. Day 1 is the day after you close escrow. Day 45 is when you must identify the replacement property. Day 180 is when you must close escrow on the replacement property.

COVID-related Extensions of Deadlines

If one of the exchanger’s deadlines falls between April 1, 2020, and July 15, 2020, that particular deadline will be extended to July 15, 2020. Here’s an example: if you closed escrow on April 1st, your 45-day deadline would have been May 16. Your 180-day deadline would be 9/28/2020. Since the 45-day deadline falls in between April 1 and July 15, that would be pushed out to July 15th, but your 180-day deadline remains the same! Please make sure you consult with your tax professional or consultant for more information.

Financial Requirements

To completely defer all your capital gains tax, you must do the following two things:

  1. You must buy a property that is equal or greater in value compared to what you sold. If you sold your relinquished home for $1,000,000, your replacement home must cost $1,000,000 or more.

  2. You must have equal or greater equity in the replacement property. You must invest all of the net proceeds from the relinquished property into the replacement property. If you are netting out $800,000 in proceeds, you must invest all of that into the replacement property.

If you do not do both of these things, you will owe taxes on the “boot” amount.

Same Taxpayer Requirement

The same taxpayer who transfers relinquished property must acquire the replacement property. Here are a few exceptions:

  • Disregarded single-member LLC and the sole member

  • Grantor and his grantor/revocable/living trust

  • If the taxpayer dies during the exchange, his estate or trustee may complete the exchange.

Related Party Exchanges

First, let’s define “related parties”:

  • Individuals: Parents and grandparents, your children and grandchildren, your siblings, and your spouse

  • Companies: Common ownership of more than 50%

If you are merely swapping properties with a related party, that will work, if each party holds the property for at least 2 years. If either party sells the acquired property within 2 years, both exchanges become taxable. You also should be able to sell your relinquished property to a related party. However, you generally cannot buy your replacement property from a related party.

Reverse Exchanges

This allows a taxpayer to close on the purchase before on they close on their sale. This may be due to the buyer of their relinquished property falling out of escrow; alternatively, some people just want to ensure they lock up their replacement property before they sell their relinquished property. In a reverse exchange, the taxpayer is not the entity acquiring the replacement property. The Qualified Intermediary must take the title of the replacement property for up 180 days until they close escrow on their relinquished property. The QI sets up an LLC specific to the transaction and this LLC is referred to as the EAT, or Exchange Accommodation and Titleholder.

There are a few benefits to the Reverse Exchange:

  • You can close on the purchase of your replacement property without a contingency

  • You avoid having to worry about the 45-day identification process

The drawbacks of a Reverse Exchange:

  • You will have to be able to finance the purchase of the replacement property without the proceeds of the relinquished property

  • Additional costs involved

Previous
Previous

Down Payment 101: PMI versus FHA Loans

Next
Next

A Detailed Look at the Home Buying Process from the Buyer’s Perspective