Putting off the Tax Collector – Basics of 1031 Exchange Rules

Reinvest Your Capital and Avoid Capital Gains Taxes

What does 1031 exchange mean to investors? One of the consequences of selling an appreciated investment is the assessment of taxes on any capital gains. That investment can be a stock, collectibles, or investment real estate.

Fortunately, Section 1031 of the Internal Revenue Code (IRC) provides a safe harbor enabling real estate investors to defer payment of capital gains tax. They can also advantage depreciation recapture and Affordable Care Act taxes if they promptly replace the property sold with “like-kind” assets. These transactions are called 1031 exchanges. Below is an overview of the 1031 exchange rules and the process of receiving tax benefits.

An Overview of the 1031 Exchange Rules

Section 1031 of the IRC provides, “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.”

In essence, if you sell investment real estate or real estate used for business purposes, and then promptly “replace” it with “like-kind” real estate, the statute allows you to defer payment of taxes on the gain. The definition of like-kind is construed very broadly for real estate. Almost all real estate is considered “like-kind” to all other real estate. Thus a commercial building may be exchanged for an apartment, farmland, or oil and gas royalties as well as a different commercial property. Ideally, before you list your property for sale, speak with your accountant or tax advisor to see if your property is eligible.

Assuming all of the rules are strictly followed, the investor’s tax basis in the sold property will carry over to the replacement property, and the capital gains tax and depreciation recapture that ordinarily would be assessed at the time of sale will instead be levied when the replacement property is sold.

How to Get Your Tax Benefits

So how can you avail yourself of this tax benefit? To get started, you will first need a qualified intermediary (QI), also known as an exchange accommodator, to hold your sale proceeds for the duration of the exchange transaction. QIs are often affiliated with banks or title companies, their reputations will be evidenced by an established track record, and they should not be related to the exchanging party. Having a QI is critical because any sale proceeds disbursed directly to the investor cannot be part of the 1031 exchange.

Next, you will enter into contracts to sell your property and buy one or more replacement properties with the proceeds. The QI will provide language to be included in the purchase and sale contracts to indicate that an exchange is taking place. In a traditional exchange, the sale of your “relinquished property” will happen first. When you close, the QI will hold all of your net sale proceeds until you are ready to acquire your replacement property.

You have 45 days from the date your sale closes to identify potential replacement properties. This is called the identification period. You may identify multiple replacement properties, either together or in the alternative. For example, you can identify three potential replacement properties of any value (3-property rule) or you can identify more than three properties with an aggregate value of up to 200% of the value of what you sold (the 200% rule). Or you can identify a property by purchasing it outright during your identification period. However, in order to completely defer your taxes, the value of all of the replacement property you ultimately acquire must be greater than or equal to the value of what you just sold.

What That Means

Note that the value of both your relinquished property and any replacement property includes the amount of any mortgage debt. Many people get confused by this point. As a rule of thumb, the IRS looks at the price your buyer pays you as the value of the relinquished property and the price you pay your seller(s) as the value of the replacement property. Whether some or all of the funds come from a mortgage loan is not important for 1031 exchange purposes.

Here’s an example. If you have a $500,000 mortgage on your property, and you sell it for $1.5 million, your replacement property must be worth at least $1.5 million, even though you only have $1 million in cash proceeds. If you want to completely defer your taxes, you will either have to buy replacement property with mortgage loans of $500,000 or more. Or you will have to contribute $500,000 of outside cash to supplement the $1 million sitting in your QI account.

In this example, your replacement property may be another $1.5 million (or greater) property, two $750,000+ properties, or even three $500,000+ properties. As noted above, the rules permit you to identify alternatives in case one or more of your options does not work out. Additionally, if you buy replacement property but spend less than the value of your relinquished property, you will pay tax on the difference.

If you want to completely defer your taxes, it is prudent to buy slightly more expensive replacement property than what you have sold, as some transaction costs may be ineligible for the exchange under the IRC.

The Bottom Line to Making 1031 Exchanges

Whatever you choose, you must acquire all of your replacement property within 180 days of your initial sale. Any proceeds that are not reinvested in the 180-day exchange period will be returned to you, and you will be subject to any taxes due on that amount.

As noted above, the 1031 exchange rules are very specific, and this article merely provides an overview. The rule that is not in the tax code is perhaps the most important: you should consult your accountant or a knowledgeable tax advisor before undertaking any exchange.

Read More:

1. The Risks, Rewards, and Challenges of Buying Real Estate
2. A Diversified Real Estate Portfolio Is Sound Investment Strategy

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

1. Investing in Commercial Property 2022
2. Real Estate Investing 101
3. Selecting the Right Valuation Expert 2021

This is an updated version of an article published on November 8, 2019. It has been updated by the author and Maryan Pelland]

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