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What is the 1031 Tax Deferred Exchange? Learn the 1031 Exchange Rules.
Do you own investment real estate in the United States (apartments, office, single-family home, land, etc) that is not your primary residence? Did you know you can defer taxable gains when you sell your property? You may be eligible to sell the investment, invest in another real estate asset and defer capital gains tax. This tax deferment strategy is called a like-kind exchange or 1031 exchange after Section 1031 of the Internal Revenue Service tax code that created these like-kind exchanges.
In this article, Crowd Street briefly outlines how commercial real estate (CRE) investors can take part in an exchange. In an effort to demystify the exchange process below are a few common questions related to this CRE tax strategy. Looking for exchangeable investments?
1031 Tax Deferred Exchanges, A Simple Explanation
Under Section 1031, the CRE equity from a sold real estate asset can be reinvested into an equal or greater valued CRE asset and gains associated with the sale can be deferred. By reinvesting the value from your sold property into a new CRE investment the value from your sold property is transferred (a like-kind exchange) into the new property and is not recognized as a taxable event.
Due to unique and time-sensitive requirements, it is not a generally well-understood investment option, however, if executed properly can result in significant tax savings for CRE investors. In an effort to demystify this process Crowd Street has summarized key questions and terminology related to exchanges.
What is a 1031 exchange?
An exchange is a tax deferral tool that enables investors to exchange their equity from one property to another instead of paying tax upon the sale of one asset. The IRS Section 1031 enables investors to defer potential taxes from a sale from one asset, and instead, transfer the value from the sold asset (relinquished property) to another real estate purchase (replacement property). The asset that is being acquired must be equal or greater in value than the one that is being relinquished.
What are the 1031 Exchange Rules?
Investors with CRE investment properties can complete an exchange so long as that property is not a primary residence (a primary residence is one in which the taxpayer has lived in the property 2+ years out of the past 5 years). It is possible to exchange from one real estate asset type to another, for example, an investor could sell land and exchange the value of the land to purchase an apartment building. Land, single-family homes, apartments, commercial office, and industrial buildings (to name a few) can all be exchanged.
Steps for completing an 1031 exchange for real estate
Set up an account with an Exchange Accommodator: To complete a valid exchange, the investor/taxpayer cannot receive funds from a CRE sale escrow, this would trigger a taxable event. An exchange account with a qualified intermediary (aka an exchange accommodator) will enable the investor to hold exchange funds during the period between the sale and purchase of investment real estate. The accommodator will facilitate the receipt of funds from the sale, deposit of funds into an acquisition escrow and all of the paperwork involved with the sale including the identification of replacement properties.
Identify a Replacement Asset within 45 days: After the closing, investors have 45 calendar days (not business days!) to identify a property or properties they plan to purchase (identification must be in writing). The exchange accommodator typically provides the identification form to be completed and investors can change their list of identified properties during the 45 day period.
Close within 180 days: Investors must complete a purchase within 180 calendar days from the date of closing. In order to close using your exchange proceeds, your accommodator will facilitate the transfer of documents and funding in coordination with your escrow company.
1031 Exchange Identification Rules: Three options exist for identification of replacement properties. Regardless of the option chosen, investors must purchase at least one property from the identified property list and cannot revise the identification after the 45 day period is over: 'Three Property Rule' (most common) Identify up to three replacement properties of any value that are planned to be purchased within 180 days from sale.
'200% Rule': Identify an unlimited number of replacement properties that have an aggregate Fair Market Value (FMV) up to 200% of your relinquished property value.
'95% Rule': Identify an unlimited number of replacement properties but must acquire 95% of the aggregate FMV identified
'Three Property Rule' (most common) Identify up to three replacement properties of any value that are planned to be purchased within 180 days from sale.'200% Rule': Identify an unlimited number of replacement properties that have an aggregate Fair Market Value (FMV) up to 200% of your relinquished property value.'95% Rule': Identify an unlimited number of replacement properties but must acquire 95% of the aggregate FMV identified
'Three Property Rule' (most common) Identify up to three replacement properties of any value that are planned to be purchased within 180 days from sale.
'200% Rule': Identify an unlimited number of replacement properties that have an aggregate Fair Market Value (FMV) up to 200% of your relinquished property value.
'95% Rule': Identify an unlimited number of replacement properties but must acquire 95% of the aggregate FMV identified
Can I acquire my replacement asset prior to selling my relinquished property?
Yes, this is called a reverse 1031 exchange. In a high-demand, supply-constrained market this may be the only way to complete an exchange. Investors still have a 180-day window from their acquisition to sell (relinquish) another asset to complete the exchange.
I don't want to manage an investment property myself, can I use proceeds from my relinquished property to purchase a more passive syndicated replacement property?
Yes, the two most common structures to complete an exchange are 1. Delaware Statutory Trusts (DSTs) and 2. Tenancy-in-Common (TiC). Whether a syndicated DST, TIC or privately held investment property, the vesting for the taxpayer from the relinquished and replacement assets (ownership structure such as trust, individual, LP/GP, etc) must remain the same. For example, while it is possible to exchange from a single-family home investment property to a DST, if the investor-owned the home in a family trust that same family trust must complete the acquisition of the replacement asset in the DST.
Is investing all capital from the sale enough to complete the 1031 exchange and defer all taxable gains?
Re-investing all of the capital from a sale is not enough to completely defer taxes from the sale investors must replace no less than the entire value (both cash and debt, if applicable) of a relinquished asset. If an investor uses all of his/her capital from the sale but does not replace the entire value of the relinquished property, capital gains can still be owed by the investor even though all sale capital has been used.
Important terminology:
Relinquished property: the property being sold as part of the exchange, also known as the 'down-leg' in the exchange
Replacement property: the property being acquired as part of the exchange, also known as the 'up-leg' in the exchange
Qualified Intermediary: (aka exchange accommodator) the entity managing your paperwork and holding your proceeds between the sale and purchase of assets
Vesting: the legal structure of the entity that has title to an asset
Fair Market Value (FMV): the total value of the exchange (sale price) including both cash to invest and if applicable the loan value (debt) associated with a given asset
Boot: term commonly used to describe taxable gain that can be incurred or received as part of an exchange
Relinquished property: the property being sold as part of the exchange, also known as the 'down-leg' in the exchangeReplacement property: the property being acquired as part of the exchange, also known as the 'up-leg' in the exchangeQualified Intermediary: (aka exchange accommodator) the entity managing your paperwork and holding your proceeds between the sale and purchase of assetsVesting: the legal structure of the entity that has title to an assetFair Market Value (FMV): the total value of the exchange (sale price) including both cash to invest and if applicable the loan value (debt) associated with a given assetBoot: term commonly used to describe taxable gain that can be incurred or received as part of an exchange
Relinquished property: the property being sold as part of the exchange, also known as the 'down-leg' in the exchange
Replacement property: the property being acquired as part of the exchange, also known as the 'up-leg' in the exchange
Qualified Intermediary: (aka exchange accommodator) the entity managing your paperwork and holding your proceeds between the sale and purchase of assets
Vesting: the legal structure of the entity that has title to an asset
Fair Market Value (FMV): the total value of the exchange (sale price) including both cash to invest and if applicable the loan value (debt) associated with a given asset
Boot: term commonly used to describe taxable gain that can be incurred or received as part of an exchange
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The information in this article is not intended to constitute legal, financial, or tax advice and should not be used in lieu of any professional's advice.
Resources:
IRS Fact Sheet-https://www.irs.gov/newsroom/like-kind-exchanges-under-irc-code-section-1031
Federation of Exchange Accommodators:https://www.1031.org/
