A 1031 Exchange, also known as a like-kind exchange, is a valuable and frequently used tool to defer taxable gains on real estate investment. Let the Sharko|Weisenbeck|Mendoza Group team of experts help walk you through the rules and regulations of a 1031 exchange.
Understanding a 1031 Exchange
What is a 1031 Exchange?
A 1031 Exchange, also referred to as a like kind exchange, is an opportunity for a taxpayer to defer capital gains taxes by selling a qualifying asset and acquiring another qualifying asset in a defined time period.
When a 1031 Exchange is successfully completed, the taxpayer defers the taxes that would normally be due on the sale of their real estate by acquiring new real estate within 180 days and following the rules listed in Section 1031 of the Tax Code.
The strict rules and time limitations can make the process overwhelming. Our team can assist in seamlessly executing these exchanges and provide timely options for a subsequent investment that fits the client’s needs. Below we have outlined a few of the critical rules and advantages for a 1031 Exchange.
1031 Exchange Rules
- The tax payer who sells must be the same tax payer who buys
- Must identify that you are completing a 1031 exchange prior to closing on the existing property
- Funds from the sale of the relinquished property must be placed with a qualified accomodator or intermediary, an independent person, company, or entity that enters into a written agreement with the exchanger to facilitate the transfer of proceeds from the exchanger to the buyer of the relinquished property and from the exchanger to the seller of the replacement property.
- Within 45 days after closing on the relinquished property you must identify a replacement property or properties using one of the below scenarios:
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- Under the Three Property Rule the exchanger may identify up to three properties, regardless of value, as long as he or she closes on one of them to be the replacement property.
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- Under the 200% Rule, the exchanger may identify more than three properties provided their combined value does not exceed 200% of the fair market value of the relinquished property.
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- The 95% Rule allows an investor to identify an unlimited number of potential replacement properties, without regard for valuation, provided they actually acquire 95% of the aggregate identified value within the exchange period.
- Purchase price must be greater than or equal to the property being sold. If it is less than, the difference may be taxed
- The exchange must be completed within 180 days after closing on the relinquished property or properties
- Owner should have owned the exchanged property for at least two years
Advantages to Exchanging a Property
- Deferral of taxes
- Relief from burden of management – i.e. selling a management intensive asset like an apartment building for a triple-net lease or ground lease such as a McDonald’s
- Ability to reinvest into a higher cash flowing property
- Utilize the money a seller would have paid to the IRS in taxes, thereby increasing their down payment and improving their overall buying power to acquire a larger replacement property.
- Increase Basis for Fully Depreciated Assets – Investors holding onto investment property for extended time periods run out of depreciation expense when the asset matures to its full useful life for tax purposes. By doing a 1031 exchange, the investor has the potential to restore basis and start the life of a depreciable asset all over again.
- Transferring out of an undesirable asset
- Opportunity in invest in a portfolio or diversify
- Transition into a new product type
- Wealth building tool
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- Legacy wealth – taxes are not handed down to the family members who inherit the properties
- Exposure to new markets
1031 Exchange Example
Joe owns a 10 unit apartment building. The property was purchased 10 years ago for $1,000,000. Joe is tired of the management responsibilities as he is nearing retirement age. He decides to hire a broker to market the asset, and ends up selling it for $2,000,000. Prior to closing, Joe chooses to defer his taxable gain though a 1031 exchange. He selects a qualified intermediary/accommodator who accepts the proceeds from the sale at the time of closing. Within the next 45 days, Joe decides to identify a quick service restaurant void of any management responsibilities. He signs a purchase agreement to acquire the restaurant, using all of his proceeds from the apartment building sale. At closing, Joe works with his 1031 intermediary/accommodator to use the funds from the relinquished property to close on the acquisition. At the end of the process, Joe will own the new property in the same entity in which he sold the relinquished real estate.
There are numerous situations in which a 1031 exchange might be a tax-efficient approach to preserve your capital. The information provided here is for general informational purposes only. It is not intended to replace competent legal, tax or financial planning advice. If you’re thinking about using a 1031 exchange, we suggest contacting your tax advisor to discuss the transaction in greater detail.