Section 1031 Exchange Replacement Property Rules
Let us start off with what most people are looking for the steps for a 1031 exchange.
Here are the 8 steps of a 1031 exchange:
- First, sell your investment property.
- Then, give the capital gains to a qualified intermediary.
- Identify a like-kind property within 45 days of sale.
- Send a duty letter to your qualified intermediary.
- Negotiate with the seller of the property.
- Agree on a sale price.
- Have your intermediary wire the capital gains to the title holder or title company.
- Lastly, Fill out IRS Form 8824.
What’s a 1031 Exchange in real estate?
Thanks to IRC (Internal Revenue Code) Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all the capital gain taxes. The reason it’s called 1031 is that it’s IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
How To Do a 1031 Exchange
To understand the powerful opportunity and protection a 1031 exchange offers, consider the following example:
- Assume an investor has $500,000 in gain and also $500,000 in net proceeds after a property closing. Assume an investor with a $500,000 capital gain and incurs a tax liability of approximately $175,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $325,000 in net equity remains for reinvestment in new property.
- Assume a 25% down payment and taking on new financing for the purchase with a 75% loan-to-value ratio, the investor would only be able to purchase approximately $1,500,000 replacement property.
- If the same investor chose to exchange, however, he is able to reinvest the entire gross equity of $400,000 for the purchase of approximately $2,000,000 replacement property, assuming the same down payment and similar loan-to-value ratios.
This is a good example which demonstrates how tax-deferred exchanges allow an investor to defer capital gain taxes as well as facilitate significant investment portfolio growth, plus an increased return on investment.
In order to access the potential of these smart benefits, it is crucial to have a comprehensive knowledge of the exchange process and the Section 1031 code. For example, an accurate understanding of the key term like-kind – often mistakenly thought to mean the same exact types of property. However, this can lead to possibilities which might have be dismissed or overlooked.
1 Simultaneous Exchange
A simultaneous exchange occurs when the replacement property and relinquished property close on the exact same day. As the name (simultaneous exchange) implies, these closings occur at the same time.
It is important to understand that the exchange must occur simultaneously; any delay, even a short delay caused by wiring money to an escrow company, can result in the disqualification of the exchange and the immediate application of full taxes.
There are three basic ways that a simultaneous exchange can occur.
- Swap or complete a two-party trade, whereby the two parties exchange or “swap” deeds.
- A three-party exchange where an “accommodating party” is used to facilitate the transaction in a simultaneous fashion for the exchanger.
- Simultaneous exchange with a qualified intermediary who structures the entire exchange.
2 Delayed Exchange
The delayed like-kind exchange, which is a much more common type of exchange chosen by 1031 investors today, occurs when the exchangor relinquishes the original property before he acquires the replacement property.
In other words, the property the Exchangor owns (which is called the “relinquished” property) is transferred first and the property the Exchangor wishes to exchange it for (the “replacement” property) is acquired second.
The Exchangor is responsible for marketing the property, securing the buyer, and executing a sale and purchase agreement before the delayed exchange can be initiated. Once this has occurred, the Exchangor must hire a third-party Exchange Intermediary to initiate the sale of the relinquished property. The Intermediary holds the proceeds from the sale in a binding trust for up to 180 days while the seller acquires a like-kind property.
Using this strategy, an investor has a maximum of 45 days to identify the replacement property and 180 days to complete the sale of their property. Beyond the numerous tax benefits, this extended timeframe is one of the reasons that the delayed exchange is so popular.
3 Reverse Exchange
A reverse exchange, also known as a forward exchange, occurs when you acquire a replacement property through an exchange accommodation titleholder before you identify the replacement property. In theory, this type of exchange is very simple. The idea is you buy a property first and you pay later.
This option requires all cash, which makes reverse exchanges tricky. It’s also common for many banks not to offer loans for reverse exchanges. The taxpayers must also decide which of their investment properties are going to be acquired and which will be parked. A failure to close on the relinquished property during the required 180 day period that the acquired property is parked will result in a forfeit of the exchange.
The reverse exchange follows many of the same rules as the delayed exchange. However, there are a few key differences:
- Taxpayers have 45 days to identify what property is going to be sold as the relinquished property.
- After the initial 45 days, taxpayers have 135 days to complete the sale of the identified property.
- Close out of the reverse 1031 exchange with the purchase of the replacement property.
4 Construction Exchange
A construction or improvement exchange allows taxpayers to make improvements on the replacement property by using the exchange equity. The taxpayer can use their tax-deferred dollars to enhance the replacement property while it is placed in the hands of a qualified intermediary for the remainder of the 180 day period.
It is important to understand that the taxpayer must also meet three requirements if they want to defer all of the gains from the sale of the relinquished property. The following are required as part of the construction or improvement exchange.
- The entire exchange equity must be spent on completed improvements or as down payment by the 180th day.
- The taxpayer must receive substantially the same property that they identified by the 45th day.
- The replacement property must be equal or greater in value when it is deeded back to the taxpayer. The improvements must be in place before the taxpayer can take the title back from the qualified intermediary.
What Real Estate 1031 Exchange Rules Must I Follow?
Rule 1 Like-Kind Property
To qualify as a 1031 exchange, the property being sold and the property being acquired must be what is referred to as like-kind.
Like-Kind Property Definition: Like-Kind property is a broad term which means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” In other words, you can’t exchange a truck for a medical building, because they’re not the same asset. Basically, you can exchange almost any type of property, as long as it’s not personal property.
- Exchanging a rental property for a restaurant space would be allowed.
- Exchanging a single family rental property for a commercial office building would be allowed
- Exchanging an apartment building for a duplex would be allowed.
IMPORTANT: The original and replacement property must be located within the U.S. to qualify under section 1031.
Rule 2: Investment or Business Property Only
A 1031 exchange is only applicable for Investment or business property. Personal property does not qualify. Basically, you can’t swap one primary residence for another.
- If you moved from Michigan to Florida, you could not exchange your primary residence in Michigan for another primary residence in Florida.
- If you were to get married and move into the home of your new partner, you could not exchange your current residence for a vacation property.
- If you own a single-family rental property in Michigan, you could exchange it for a commercial rental property in Florida.
Rule 3: Greater or Equal Value
In order to avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax.
For example, let’s say you have a property worth $3,000,000, and a mortgage of $500,000. To receive the full benefit of the 1031, the new property (or properties) you purchase need to have a net worth of at least 3 million dollars, and you’ll have to carry over at least a $500,000 mortgage. It’s important to note that the $3,000,000+ value, and $500,000 mortgage, can go towards one apartment building or four different properties with a total value of $3,000,000+.
It’s worth noting, acquisition costs, such as inspections and broker fees also apply toward the total cost of the new property.
Rule 4: Must Not Receive “Boot”
A Taxpayer Must Not Receive “Boot” in order for the exchange to be completely tax-free. Any boot received is taxable to the extent of gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax-free. The difference is called Boot. This is the amount you will have to pay capital gains taxes on. This option is completely okay, and is common when a seller wants to make some cash, yet is willing to pay some taxes to do so.
An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under section 1031 is worth $1,000,000, you would need to pay the normal capital gains tax on the $1,000,00 boot.
Rule 5: Same Tax Payer
The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder which buys the new property. However, an exception to this rule occurs in the case of a single member limited liability company, which is considered a pass-through to the member. Therefore, the single member limited liability company may sell the original property. This sole member may purchase the new property in their individual name.
For example, the single member of “John Smith LLC” is John Smith. The LLC can sell the property owned by the LLC, and because John Smith is the sole member of the LLC, he can purchase property in his name, and be in compliance with the 1031 code.
Rule 6: 45 Day Identification Window
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind.
An exception to this is known as the 200% rule. In this situation, you can identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.
Rule 7: 180 Day Purchase Window
It is necessary that the replacement property is received and the exchange completed no later than 180 days after the sale of the exchanged property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.
1031 reverse exchange
A reverse exchange is the purchase of the replacement property prior to closing on the relinquished property. An investor may need to consider a reverse exchange in a seller’s market, where properties are selling at a fast pace and inventory is low. The most common variation (often referred to as park the replacement property) involves the Qualified Intermediary first purchasing the replacement property. When the relinquished property is sold at a later date, the Qualified Intermediary completes the exchange by deeding the replacement property back to the Exchanger. It is especially crucial that the Qualified Intermediary has in-depth knowledge of the steps and precautions necessary in these complex transactions. Working with an investor’s tax advisors and attorneys, API draws upon substantial experience with reverse exchanges to help lead the investor safely through a minefield of potential hazards.
Turning 1031 Exchange Property into Your Personal Residence
When you sell your personal residence, the IRS says $500,000 of the gain ($250,000 if you’re single) is tax-free. There are some things that you have to do to qualify for this benefit, however, the most important of which is that you must live in the house for at least two of the last five years.
There is a different code section, Section 1031, that says if you sell a house that’s been a rental for at least the last year (or two years in some situations), you can roll the gain from the old house to the new house and defer the tax on the gain until you sell the new house.
Sometimes these two IRS rules overlap. For example, when you sell your residence, it has to have been your residence for two of the last five years. Two of the last five… so what was happening during the other three years? Well, if you’ve lived in the house for all five years there’s no problem – just sell the property and $500,000/$250,000 of gain is forgiven.
However, if you have rented the house during the other three years, especially if one of those years is the year before you sell it, you could do a 1031 exchange and roll the gain over to another investment property and defer the tax.
However, you should consider this option seriously as you might turn tax-free, never-to-be-taxed-again gain from the sale of a residence into a 1031 gain that WILL be taxed someday. Given the choice, ALWAYS, take the tax free option.
An exception to the rule that $500,000/$250,000 of the gain is tax-free involves a residence that was purchased with 1031 exchange proceeds. The IRS has special rules for taxpayers who buy a rental property as their 1031 replacement property and later move into the same property. For example, if you sold a rental property in Detroit, did a 1031 exchange and bought a property in Miami, Florida, rented it out for several years, and then moved into it as your primary residence for a couple of years, your excluded gain when you sell the Miami house could include some of the gains that are rolled into it from your exchange.
The IRS penalizes you for the time that your property is not your primary residence. You must prorate the gain between the periods the property was your primary residence, and the periods that it was not. Your primary residence is the place which you live.
Can I make a gift with a 1031 exchange?.
Can you gift an interest in a property resulting from a 1031 exchange into a 529 plan for grandchildren?
Federal tax code section 529 provides for qualified tuition programs, commonly called 529 plans.
Federal tax code section 529(b)(2) states, A program shall not be treated as a qualified tuition program unless it provides that purchases or contributions may only be made in cash.
On the other hand, property from a 1031 exchange is likely a rental property. A 1031 exchange is found in tax code section 1031. That law provides that gain or loss from the sale of a business or investment property will be avoided (deferred) upon acquisition of a like-kind replacement property. Absent the acquisition of the replacement property, the taxpayer would recognize gain or loss upon the sale of the business or investment property.
Therefore, the short answer is that you can’t contribute previously received 1031 replacement property to a 529 plan. The contribution must be cash. If a taxpayer wishes to contribute previously received 1031 replacement property to a 529 plan, she must sell the property, which triggers the taxable gain avoided earlier in the 1031 exchange. Then she can give the cash proceeds.
Make sure you understand the sum of the federal and state tax liability upon selling a property obtained in a prior 1031 exchange. The results may be surprising.
Here is an example Joseph obtained property called “Sunny Farms” in a 1031 exchange. He paid $300,000 for Sunny Farms, but his cost for determining gain or loss was $100k (because he deferred gain of $200,000 in the earlier 1031 exchange). Now, Joseph wants to sell Sunny Farms because its value fell to $250,000. If he sells Sunny Farms, he will have a taxable gain of $150,000 ($250,000 sale price minus tax cost or “basis” of $100,000), even though he lost $50,000 economically on Sunny Farms.
1031 Exchange for Real Estate Investors
1031 exchanges are most often used by real estate investors. If you are thinking of selling an existing rental property, for example, and want to buy another like-kind property, then a 1031 like kind exchange is a great option because you can defer taxes on your sale. Generally, any real estate property held for the productive use in the trade or business or for investment qualifies for a 1031 exchange.
This means that commercial real estate or investment can be exchanged for residential real estate investments and vice versa. For example, a shopping center can be exchanged for a multifamily property or apartment building. In cases like these, investors will typically use the profits as a down payment and cover the rest of the purchase with multifamily financing or an apartment loan.
There are also 1031 marketplaces that offer a diversified portfolio of real estate investments that are considered “like-kind” to real physical property. So, you could feasibly exchange your investment property for a pool of investment properties and take advantage of passive income. This is attractive to investors who don’t like the hands-on approach of being a landlord.
What’s more, most long-term investors looking to execute a 1031 exchange consider a turnkey real estate property, which is a rent-ready rental with existing tenants already in place. This is beneficial for investors who want to find a cash flow positive property quickly before the 45-day identification window expires. For more information, you can read our guide on the best turnkey real estate companies.
There is no minimum “hold time” with a 1031 exchange, however almost all properties are long-term investments so are taxed at the long-term capital gains tax rate. Although there isn’t a set hold time, a 1031 exchange is not meant for fix-and-flippers, since it’s supposed to be used on long-term investment properties.
1031 Exchange for Business Owners
If you’re a business owner thinking of selling your business and investing in another one, then a 1031 exchange might also be right for you. A business is typically comprised of real property like real estate, personal property like tangible and intangible assets, and goodwill. Under a 1031 exchange, real property and personal property can be exchanged for like-kind properties.
This means that you can only exchange real estate for real estate and tangible assets for tangible assets. Goodwill doesn’t qualify for a 1031 exchange. The definition of like-kind real estate is fairly loose. For example, a business can exchange its commercial property for residential property and vice versa.
Like-kind tangible assets are a bit more restricted and include depreciable tangible property and depreciable intangible property. Unfortunately, non-depreciable property are not all considered like-kind. This means that you might not be able to exchange a depreciable asset like a machine for a patent or something similar.
Overall, it’s easiest to sell and purchase similar businesses with similar assets. Two restaurants with similar commercial properties and equipment, for example, would be a good candidate for a 1031 exchange.
Examples of 1031 Exchanges
A couple purchases a small apartment building in California 10 years ago for $1.5 million. The couple puts $500,000 of their own money down, and takes out a mortgage for the $1 million.
After a number of years, the couple’s adjusted basis in the property may show the purchase price, the acquisition cost (such as title insurance) of $10,000, plus capital improvements (such as a new roof) of $65,000, minus the depreciation over the time they’ve owned the property of $400,000. Without taking into account deferred capital gains, the property’s adjusted tax basis at sale would be: $1.175 million.
The couple decides to sell their property. They think they could price it at $2.85 million, less closing costs on the relinquished property of about $50,000, making the net selling price $2.8 million. Subtract from that the adjusted tax basis of $1.175 million, and the realized gain on the sale would be $1.625 million.
But that is different from the net cash received. For that, take the sale price of $2.85 million; subtract about $800,000 paid down on the mortgage, and the closing costs on the relinquished property and the net cash received at the sale would be $2 million.
Now, the couple needed to estimate their tax liability from the sale. Assuming a realized gain of $1.625 million on the sale, they’d have to estimate their Capital Gains tax on the sale of about 20%, or $245,000; the federal tax on Depreciation Recapture of 25%, or $100,000; the Affordable Care Act tax surtax of 3.8%, or $61,750; and the California State Capital Gains Tax of 12.3%, or $199,875, resulting in an effective tax rate of 37.3%, or $606,625.
By using a 1031 Exchange strategy, the couple may be able to defer their 37.3% liability in taxes and keep all their profit from the sale. With the 1031 Exchange, they have $2 million in equity available to reinvest after the sale, instead of $1,393,375 ($2 million minus the taxes paid of $606,625).
To defer all of their property taxes, the Replacement Property must have a purchase price and mortgage balance equal to or greater than the Relinquished Property being sold. Investors aren’t required to invest all of their sale proceeds into the Replacement Property, but then they are doing what is called a “Partial Exchange,” and what is not reinvested is referred to as “Boot,” which is subject to taxes.
Essentially, any investment property other than your primary residence can qualify for an exchange. The IRS considers any investment property as “like kind.” Meaning, they don’t even have to be the same type. Raw land can be exchanged for an office building, and an exchange can be conducted between any two properties in the U.S., or even multiple properties, or Replacement Property Interests – in which the investor owns a proportionate share of property along with others.
You are a real estate investor, and you bought a residential investment property two years ago for $50,000. You own it outright. You get it appraised and find its current worth is $100,000. If sold, the property would have a capital gain of $50,000, and about $5,000 in capital gains tax.
You decide to sell your property and purchase a larger property with your capital gains, deferring the capital gains tax on the sale, depreciation recapture, and maybe state taxes, using a 1031 Exchange.
First, you try to sell your property for $100,000 using a real estate agent, knowing it could result in $50,000 in capital gains from your initial purchase price. When the title is transferred, the clock starts running on the 45-day identification process.
You find a qualified intermediary, who holds your capital gains on the sale almost like an escrow account. Within the 45-day period, you send the qualified intermediary a letter listing the properties you have identified for a 1031 Exchange. Up to three properties can be on the list, but only properties on that list can be used in a 1031 Exchange.
Once your agent finds a like-kind property within those 45 days for $150,000, you’ll have six months from the sale to close on the like property. Once the seller agrees to sell the property to you for $150,000, you instruct your qualified intermediary to wire the $50,000 in capital gains – usually to a title company.
The remaining $100,000 cost of the property would have to be financed either by debt or additional equity, but the $50,000 in capital gains would be deferred, as would the $5,000 in capital gains tax.
You want to sell your commercial property for $600,000. You bought it for $400,000 as an investment. Meaning, the sale will generate a $200,000 taxable capital gain.
If you use a 1031 Exchange strategy, you can defer your capital gains tax with a swap for a like-kind property – another property similar to the one you’re selling. But you must identify a like-kind property within 45 days of selling your commercial property. If you do not, you could be subject to a capital gains tax as well as state capital gains.
To ensure compliance, you contact a qualified intermediary who is like an escrow company, to make a qualified exchange arrangement — the intermediary will transfer your property to the buyer, and transfer the replacement property to you.
Companies that Offer 1031 Exchange Help
Completing a 1031 exchange can be difficult so you shouldn’t attempt it without the help of a professional. For example, business owners and real estate investors will typically want to work with 1031 exchange firms, intermediaries, and marketplaces to help facilitate their like-kind transaction. Working with these people ensures that you comply with all of the IRS’s requirements.
The following are some companies that offer help with your 1031 exchange:
1031 Exchange Firm
A 1031 exchange firm is a firm that is dedicated to assisting you with 1031 like kind exchanges. Unlike a CPA or a financial planner, their sole focus is on 1031 exchanges so they know the ins and outs and the IRS requirements. This firm will be your intermediary and your advisor and is beneficial if you want help during the entire process and aren’t sure who else to turn to. A 1031 exchange firm can help facilitate your 1031 exchange in lieu of a qualified intermediary.
1031 drop and swap
At 1031 Exchange Place, one of the most common questions we get as we provide comprehensive 1031 exchange services is this: I want exchange benefits, but my business partners want to cash out – what can I do? Can I do a 1031 exchange in a partnership?
In short, the answer is often ‘yes’ – using a procedure called the “Drop and Swap.” However, there are some important requirements that need to be understood.
Two Vital Requirements
- It’s not directly stated in section 1031 of the tax code, but there’s a general rule that in order for these exchange transactions to count as ‘like kind’, the same person who sells the property is required to be the one who replaces it as well. Down similar lines, whoever holds the title for the relinquished property must be on the title for the new one.
- In addition, per IRS Section 1031(a)(2)(D), interests in partnerships are not exchangeable – as such, the interest has to be transitioned to a tenant in common interest before a 1031 exchange can take place.
When It Gets Complicated
This is simple enough in some cases, but in others, it can get a bit complex. If you’re part of an LLC, partnership or trust where other members are looking to cash out but you or other parties in the arrangement want to use a 1031 exchange to defer capital gains, the most common technique here is the “Drop and Swap.”
During a Drop and Swap transaction, you’re basically “dropping” yourself from your partnership – instead, it becomes a tenant in common relationship with your partners. From there, you then “swap” into a replacement property. In essence, the Drop and Swap changes the property title in this partnership, removing individual names to achieve the transfer.
1031 capital gains
One of the biggest reasons homeowners invest in U.S. real estate is because of the very favorable tax treatment received.
Not all investments work the same way. For example, if you sold $100,000 worth of Ford stock and made $75,000, you’d be taxed on that 75,000. This would apply if all you did was turn around and reinvest it in GM stock that stock would have to do very well to make up for the government taxes.
Fortunately, buying and selling homes for investment purposes doesn’t work that way. If you made $75,000 profit on the sale of a property, you could reinvest that money in another property, and defer every penny of tax on the profit, also known as the gain.
This is the advantage of the 1031 Exchange.