A 1031 Exchange (also known as a like-kind exchange) is a method to defer taxes in real estate transactions. An individual who owns any type of investment real estate is able to defer paying capital gains tax upon selling by reinvesting in a replacement property of equal or greater value. This article will cover the details of how this process works.
Here is a basic example of how a 1031 Exchange works: An investor decides to sell the townhouse they have owned and operated as an investment, and the profit (capital gains exposure) from the sale is $300,000. The federal and state capital gains taxes would be about $100,000, thus reducing the net profit from the sale to $200,000. However, if the investor elects to purchase another real estate investment property the entire $300,000 would be available and the $100,000 in taxes would be deferred.
The Qualified Intermediary
To fully understand the 1031 Exchange, an investor needs to know what role a qualified intermediary (also known as an accommodator) plays. An accommodator is a company that helps the investor through the process of the 1031 tax-deferred Exchange. The accommodator cannot be related to the investor and they cannot have had any financial dealings with the investor during the previous two years. The primary purpose of the accommodator is to hold the proceeds from the sale of investor’s property in trust while the investor searches for a new property. This is required as the IRS regulations prohibit the investor from receiving any of the proceeds, even on an interim basis, which would immediately disqualify the 1031 exchange.
Types of Exchanges
There are 4 basic forms of 1031 Exchanges:
A simultaneous exchange occurs when an investor closes on the sale of an investment property and buys a replacement property on the same day. Even though there is no timing delay the use of an accommodator is still recommended to ensure compliance with IRS regulations.
A delayed exchange occurs when an investor sells an investment property and subsequently identifies and closes on a replacement property within the prescribed time restrictions. A delayed exchange is the most common type of exchange
In the event, an investor finds a replacement property that he or she wants to purchase before selling their current investment they can complete a reverse 1031 exchange. The investor can buy the replacement property using another source of funds prior to selling the existing property.The key to completing a reverse 1031 exchange in compliance with IRS regulations is to ensure the investor does not hold title to both properties at the same time. The investor will enter into a Qualified Exchange Accommodation Agreement with the Accommodator and one of the properties will be “parked” (typically referred to as a parking arrangement) in a single purpose entity, or “SPE” established by the Accommodator. The investor then has 180 days from the purchase date to sell the existing investment property. The proceeds derived from the subsequent sale can be used to replenish the other funds used in the purchase of the replacement property.
A construction/improvement exchange allows an investor to buy land and build on it or rehabilitate a property. An improvement exchange is subject to the same timing restrictions as a delayed exchange, and the investor cannot hold title to the replacement property until all of the funds from the sale have been utilized (construction does not need to be completed but the 1031 funds do need to be exhausted). This type of exchange is more complicated and only a very experienced accommodator should be utilized.
Following the Rules
In order to use the 1031 tax-deferred exchange, an investor needs to make sure to not break any rules. The properties that are bought and sold must be “like-kind” meaning for investment purposes, so an individual who lives in a condo or single family residence and wants to buy a new home cannot defer capital gains tax by using this method. The investor needs to be operating the property as a rental.
3 Property Rule vs. the 200% Rule
As previously noted an investor has 45 days to identify a potential replacement property but there are restrictions what they can and can’t do. Essentially an investor has to follow one of two rules. The 3 Property Rule stipulates an investor can identify up to 3 properties for purchase. Alternatively, an investor can identify as many properties as they choose, provided they don’t exceed 200% of the market value of the property that was sold.
The 95% Rule
There is one exception to both the 3 property rule and the 200% rule, the 95% rule. The 95% states that both of the above restrictions can be lifted provided the investor actually purchases a minimum of 95% of the properties identified. If the investor does not then the entire 1031 Exchange is disqualified. Consequently, this rule is rarely used.
The Boot and DSTs
Sometimes an investor has money left over upon the purchase of the replacement property. This difference is called the boot. The boot can be placed into a Delaware Statutory Trust (“DST”) allowing the investor to avoid capital gains taxes. A DST is a passive real estate investment vehicle whereby the investor buys an interest in an entity that owns multiple properties. The investor has no direct control over the decision making (what and when to buy/sell) and the length of investment is typically a minimum of 5 years.
In summary, 1031 Exchanges are a great way for real estate investors to grow their real estate wealth tax-free, provided an investor follows the rules outlined by the IRS.