What Is A 1031 Exchange?
Section 1031 of the Internal Revenue Code provides an effective strategy for deferring capital gains and depreciation recapture tax that may arise from the sale of investment or business property. Since 1921, the tax code has allowed that any real estate held for investment or productive use in a trade or business may be exchanged for any other real estate that is held for investment or productive use in a trade or business. For example, an apartment may be exchanged for an office property, office for retail, raw land, a Delaware Statutory Trust (DST), etc.
Reasons To Consider A 1031 Exchange
Deferral of Capital Gains, Depreciation Recapture, & Net Investment Income Tax
Relieve the Burden of Active Real Estate Ownership & Property Management
Improve Cash Flow & Appreciation Potential
Ability to Exchange Into Higher Quality Properties
Achieve Diversification
Facilitate Estate Planning
Illustrating The Power Of Tax Deferral
When considering a 1031 Exchange it’s important to understand the potential tax implications of not exchanging. The hypothetical example below is based on the investor who purchased an investment property for $500,000 many years ago and is now contemplating a sale or 1031 Exchange based on a $2M sale price.
Sale without a 1031 exchange
Original Purchase Price: $500,000
Depreciation Taken: $500,000
Adjusted Cost Basis: $0
Sale Price: $2,000,000
Total Taxable Gain: $2,000,000
Depreciation Recapture
Tax (25% of Depreciation): $125,000
Federal Long-term Capital Gain
Liability (20% of Total Taxable
Gain less Depreciation): $300,000
State Tax (10.9%) (NY): $218,000
Net Investment Income Tax
(3.8% of Total Taxable Gain): $76,000
Total Taxes Due: $719,000
Net Proceeds for Reinvestment: $1,281,000
Sale with a 1031 exchange
Original Purchase Price: $500,000
Depreciation Taken: $500,000
Adjusted Cost Basis: $0
Sale Price: $2,000,000
Total Taxable Gain: $2,000,000
Depreciation Recapture
Tax (25% of Depreciation): $0
Federal Long-term Capital Gain
Liability (20% of Total Taxable
Gain less Depreciation): $0
State Tax (10.9%) (NY): $0
Net Investment Income Tax
(3.8% of Total Taxable Gain): $0
Total Taxes Due: $0
Net Proceeds for Reinvestment: $2,000,000
*The above chart is for illustrative purposes only. Please consult with your CPA or tax attorney.
01
Contract
Seller should have the contract specify that the sale may be structured as a 1031 Exchange by including an Exchange Addendum.
02
Relinquished Property Closing
At closing, proceeds must go directly to a Qualified Intermediary and be deposited in a qualified escrow. See section below on The Use of a Qualified Intermediary.
03
45 Day Identification Period
The replacement property must be identified within 45 days from the sale of the original (relinquished) property.
04
180 Day Exchange Period
The replacement property must be acquired within 180 days from the sale of the relinquished property, or the due date of your federal tax return, whichever is earlier.
In Order To Defer 100% Of The Taxes On The Sale Of Relinquished Property, The Exchanger Should Follow These General Rules
Purchase Replacement Property Of Equal Or Greater Value Than The Relinquished Property.
Reinvest All The Equity Into The Replacement Property.
Obtain The Same Or Greater Debt On The Replacement Property As On The Relinquished Property.
*Note: Debt may be replaced with additional cash; however, equity from the exchange cannot be replaced by increasing debt.
Identification Rules
You may follow one of three identification rules when executing a 1031 Exchange.
Three Property Rule
You may identify up to three potential replacement properties without regard to their value.
200% Rule
You may identify any number of potential replacement properties provided the fair market value of all properties identified does not exceed 200% of the fair market value of the relinquished property.
95% Rule
If you identify more than three properties and the aggregate value of the properties exceeds 200% of the relinquished property, then you must acquire 95% of the fair market value of all properties identified.
Other Considerations
Note: Neither 1031 Investment Services, LLC nor DFPG Investments, LLC provide tax or legal advice. Investors should consult with a qualified tax or legal professional regarding 1031 exchange and/or tax related issues.
The use of a qualified intermediary
A Qualified Intermediary (QI) is essential to completing a successful 1031 exchange. The QI acts as a fiduciary that holds the exchange proceeds and provides services to help keep the taxpayer in compliance with the IRS rules and laws. A QI must be an independent party to the exchange transaction, meaning the QI cannot also serve as the exchangor’s tax advisor, attorney, real estate or securities broker. Violation of this rule could result in the exchange being disallowed by the IRS. Qualified Intermediaries are not regulated or licensed, so be sure to choose one carefully. If you require assistance in selecting a QI, 1031 Investment Services can provide you with one or more from which to choose.
Partial 1031 exchanges are allowed
Taxable funds can be taken either at the closing of the relinquished property or at the completion of the exchange process. Cash received or debt not replaced will be taxable. Partial exchanges may be prudent for investors lacking liquidity.
Like-kind requirements
Replacement property acquired in a 1031 exchange must be “like-kind” to the property being relinquished. All real property held for investment or use in a trade or business is “like-kind,” regardless of whether it is improved or unimproved and regardless of the type of improvement or interest. Therefore, raw land may be exchanged for an office, a retail property may be exchanged for a multi-family, and individually owned property may be exchanged for a DST, etc.
The purpose requirement
Both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Thus, you cannot exchange into or out of a personal residence or property held for resale as a dealer.
Title requirements
The exchangor must take title to the replacement property in the same manner they held title to the relinquished property. Any taxpayer (individual or entity) can execute a 1031 exchange; this includes C corps, S corps, Partnerships, Trusts, and LLCs.
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A 1031 Exchange can be an effective way to defer taxes and retire from property
management but working with an experienced advisor who understands the real estate and knows the sponsor companies can have a tremendous effect on your ability to reach your investment goals.