06/06/2022

1031 Exchange: What Is It And When To Use Them

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What Is a 1031 Exchange?

A 1031 exchange gets its name from the Internal Revenue Code Section 1031. The Internal Revenue Service defines a “like-kind” exchange as a mutual transfer of similar commercial or investment real estate with no gain or loss. Note that 1031 exchanges apply exclusively to real estate. Securities, equities, and other asset classes are not included in the allowable set of tax deferrals.

How Does a 1031 Exchange Work?

Since it is highly unlikely that two parties in different places will agree to swap identical properties at the same time, the like-kind rule can be interpreted broadly. 

To qualify for a 1031 exchange, all properties in question must be located in the United States. They must be similar in nature but not in grade or quality. For instance, a person might exchange a larger, older warehouse requiring repairs and maintenance in a locality with higher tax liability for a smaller, newer warehouse in a more desirable area. Farmland may also qualify as a type of like-kind property.

Personal residences do not qualify for exchange if they are primarily used by the owner, friends, and family. Vacation properties are only eligible for exchange if they earn rental income and qualify as relinquished or replacement property. “Personal use” is restricted to 14 days or no more than 10% of the time the property is rented at a fair market rate. 

If a 1031 exchange includes dissimilar property, money, financing, or other liabilities that fall outside the like-kind definition, the fair market value of the “other property” is known as “boot,” and the net boot received is taxed.

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What Are the Process Requirements for a Successful 1031 Exchange?

Rome wasn’t built in a day, and a 1031 exchange is not just a simple barter of keys and deeds. The process includes several rules, procedural steps, and time constraints. The seller must retain a qualified intermediary to hold funds while each sale is underway. Sellers must identify a qualified replacement property within 45 days of opening the exchange, so it’s common to plan before filing paperwork. Often, the seller will follow the “three property rule” and identify three potential replacement properties as a contingency if the acquisition of their preferred property fails. Other strategies include the “200% rule,” which allows a seller to identify any number of appropriate replacement properties so long as their total value is not more than double the net sales value of the relinquished property. The “95% exception” requires sellers to close at 95% of any identified market valuation for the chosen replacement properties. It helps sellers who want to purchase several properties or who exceed the 200% rule due to sudden property value increases. A seller who fails to meet any of these requirements will forfeit the exchange.

Once the sale of a seller’s relinquished property is completed, the clock starts on the purchasing window for buying the replacement property. The seller must purchase the identified replacement property and transfer funds to complete the exchange within 180 calendar days, or by the due date for the income tax return for the tax year in which the previous property was sold. The seller cannot purchase the replacement property via a third party; the names on the deeds of the relinquished and replacement parties must match. If the seller misses any deadlines, the 1031 exchange fails, and the income from the property sale becomes taxable. 

After the exchange has been successfully completed, the seller will not have to pay any capital gains taxes if the cost of the replacement property was equal to or more than the relinquished property. Capital gains taxes are deferred indefinitely unless the replacement property is resold without using a 1031 exchange. In that case, the seller would pay all current and deferred capital gains taxes, so it makes sense for the seller to consider other options if raising cash is their goal. The 1031 exchange encourages investment. If the seller wants to avoid tax liability, it’s generally prudent to sell the replacement property using another 1031 exchange.

When and Why to Use a 1031 Exchange

Property Management and Investment

1031 exchanges work well for upgrading or consolidating property, or for investing in a change of locale. They create opportunities to reduce or eliminate future costs of maintenance or property management services. Sellers may also be able to leverage regional differences in growth and income potential that will make a replacement property more valuable than a relinquished property in a given number of years.

Wealth Building

1031 Exchanges may enable sellers to grow their wealth faster. They create opportunities for investment and minimize the loss of purchasing power to taxes when the money is invested in replacement property.

Estate Planning

1031 exchanges are also a helpful estate planning tool. Should the original seller pass on from this life, the deferred capital gains taxes will be erased before the property is ceded to the seller’s heirs. The cost basis of the inherited property matches the current market value, not its original purchase value. Heirs can avoid paying capital gains tax if they sell the property right away at fair market value because the sale price will equal the cost basis. If the heirs wait to sell the property and its value appreciates in the interim, they will pay capital gains taxes on the difference between the sale price and the cost basis. The heirs can elect to perform another 1031 exchange instead of selling the property outright. 

Find Professional Guidance for Your Next 1031 Exchange

While 1031 exchanges can be intimidating, they create opportunities for property ownership and wealth building. Tax deferral is a significant benefit that can maximize purchasing power for replacement properties within the rules of the exchange. Sellers should work with qualified, experienced professionals who can advise them and ensure their success.

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