If you sell rental or investment property that will get you a gain upon sale, you can avoid capital
gains and depreciation recapture taxes by rolling the proceeds of your sale into a similar type of
investment within 180 days. This like-kind exchange is usually referred to as a 1031 exchange, but
note that the rules surrounding this strategy can be so complex that your real estate agent or
financial advisor probably has a colleague whose job entirely consists of nothing but 1031
exchanges.
Often overlooked, a 1031 exchange is considered one of the best-kept IRS secrets offering
significant tax advantages to investors. In short, if your investment property has substantially
depreciated for tax purposes and/or has appreciated in fair market value, then you should consider a
1031 exchange to swap that property for another so your investment can continue to grow taxdeferred. But what is 1031?
A Quick Guide to the 1031 ‘Like-Kind’
Exchange
Typically most swaps are taxable as sales. However, under section 1031 of the Internal Revenue
Code, an investment or business real estate owner can change the form of their investment with (as
the IRS sees it) either no tax or limited tax due at the time of the exchange. In order to qualify as a
like-kind exchange, the transaction must be done in accordance with some very specific rules.
There is no limit on how many times or how frequently you can roll your investment gains over with a
- Although a profit may be gained on each swap, you avoid tax until you actually sell for cash
many years later. Then you’ll hopefully pay only one tax, and that at a long-term capital gain rate
(currently 15%).
Why should you consider a 1031 exchange?
Aside from having an opportunity to grow the value of your real estate investment portfolio while
deferring taxes, there are other advantages to using the 1031 exchange. Suppose your spouse was
transferred to a new city, you could continue to manage your properties from afar – or – you could
exchange one (or all) to fund the purchase of property in your new town.
Here are a few other reasons you might want to consider a like-kind exchange. You can..:
- Diversify your investment portfolio
- Upgrade or consolidate property
- Own multiple properties
- Relocate to a new city/state
- Change property types among residential, commercial, retail, farmland etc.
For Investment and Business Property NOT Your
Primary Home
It is important to remember that a 1031 exchange only applies to the sale/buying of investment or
business property. You cannot swap your primary residence for another home to defer capital gains.
If you read the IRS requirements, some personal property, such as valuable paintings, can qualify,
however, private residences, corporate stock or partnership interests do not qualify. There are ways
a 1031 can be used for swapping a vacation home, but even more rules apply to ensure you are not
avoiding gains on a personal home.
You May Find That ’Like-Kind’ is a Broad Term
A 1031 is often referred to as a like-kind exchange, however you may find that term doesn’t mean
what you think it means. The rules are surprisingly liberal, allowing you to exchange one business
for another, but there is fine print.
The words “like-kind” mean similar in nature or character (notwithstanding differences in grade or
quality). Like-kind exchange property includes: apartments, commercial, condos, duplexes, raw land
and rental homes.
Examples of Qualified 1031 Like-Kind Property Exchanges: - apartment building for farm/ranch
- office building for hotel
- raw land for retail space
- unimproved property for commercial property
The role of the Qualified Intermediary (QI)
We all know tax strategies can be fraught with complications which is why you need professional
help to perform a 1031 tax-deferred exchange. In most cases, a qualified intermediary (QI) is
required to successfully complete the transaction.
The QI is the ‘neutral’ party legally designated to hold the funds which facilitate a 1031 exchange. To
be qualified, the 1031 exchange intermediary must not be relative or agent of an exchanging party.
As an exception, a real estate agent may serve as a QI if the current transaction is the
only instance in which the agent has represented the exchanging party over the past
two years.
The QI performs several important functions, including holding then transferring the 1031 exchange
properties and money, as well as preparing the legal documents. The intermediary enters into a
written agreement with the taxpayer wherein they hold the proceeds from the sale of the taxpayer’s
relinquished property in a trust or escrow account before using them to purchase the replacement
property. This ensures the taxpayer does not handle the cash and therefore avoids the capital gains
tax (until the future).
What to Look For in a Qualified Intermediary (QI): - Meets the “safe harbor” requirements to insure your transaction passes a possible IRS audit.
- Is an independent facilitator who is not a relative or recent agent (2 year). This ensures there
is no risk of dis-allowance of the exchange. - Understands the details and requirements of a 1031 exchange so you have a successful
transaction. - Will team up with your trusted financial and legal advisors to address your specific needs
and answer any questions about elements of your transaction.
Completing a Typical Delayed Exchange
Usually an exchange involves a simple swap of one
property for another between two parties, but is rare
to find the exact property you want while selling your
property simultaneously. For that reason, the vast
majority of exchanges are delayed*.
You will relinquish or transfer your current investment property. The QI holds the cash from the sale
of that property and must use those funds to purchase a replacement property within 180 days. The
following will help you understand the timeline and risks of most 1031 swaps. - A reverse exchange occurs when the replacement property is purchased before the
initial property is relinquished through the same process with a QI.
Designate a Replacement Property within 45 Days
Once the sale of your property occurs and the QI receives the cash, you have 45 days to designate
at least one replacement property in writing. Most investors can designate up to three potential
properties as long as you eventually close on one of them. And within certain valuation, you can
designate an unlimited number of potential replacement properties as long as the fair market value
of the replacement properties does not exceed 200% of the aggregate fair market value of all the
exchanged properties.
Close on a Replacement Property within 180 Days
You must close on one of those designated properties within 180 days from the date your property
closed. These deadlines run concurrently; if you designate your replacement at day 45, you will have
135 days left to close on a replacement.
Getting the “Boot” Will Incur a Tax
You may run the risk of having cash left over after the QI purchases the replacement property at the
end of the 180 days. The cash you receive is known as boot and it will be subject to taxes as a
capital gain.
Suppose you had a mortgage of $1 million on an old strip mall, but your mortgage on a new
commercial building is only $900,000. You have $100,000 of gain that will be taxed. Additionally, if
you don’t receive cash back but your liability goes down, that too will be treated as income to you
just like cash.
Work with Your Financial Team to Save on
Taxes
More often, property transactions are complex and it’s not immediately obvious how or even if a
transaction can qualify for a 1031 exchange. Use the information here as a guideline. Talk with your
trusted financial advisor, your legal counsel and a tax professional about the best way to structure
your transaction to meet your needs.