A successful 1031 exchange will give you more buying power to continue building and improving your real estate portfolio. To put it another way, it’s like not paying tax on the sale of
your property as long as you use the money toward another Like-Kind investment property.
You’ll end out paying only one tax at a later date at a long-term capital gains rate.
Note that your estate attorney may have tactics that go beyond the scope of this article for
passing along property that may eliminate the capital gains tax after death. Until then, there is the 1031 and another tactic (not covered here.)
- UNDERSTANDING THE 1031 EXCHANGE
- LIKE KIND TO QUALIFY
- REVERSE 1031 EXCHANGE
- HOW TO QUALIFY A VACATION HOME
- FORM 8824
- GLOSSARY OF TERMS USED IN A 1031 EXCHANGE
- HOME BUYING SOLUTIONS
- INFORMATION DISCLAIMER
- WHERE WE WORK
UNDERSTANDING THE 1031 EXCHANGE:
A 1031 exchange is a SWAP of business or investment properties. If you rent out a house that you own as an investment subject to certain rules explained elsewhere, that investment property qualifies.
LIKE-KIND TO QUALIFY
The property exchange must be considered like-kind by the IRS for capital gains taxes to be deferred.
Like-Kind is misleading since you can sell one type of business property and buy certain other types in the same category –
like selling your vacation home that you rent out (see Timelines and Rules), and buying an apartment building as the replacement property.)
A 1031 exchange (aka Like-Kind exchange) is a swap of one investment property for another. If the property you want to exchange meets requirements,
you’ll either have no tax or limited tax due at the time of the exchange. The limited tax is called Boot (explained elsewhere).
REVERSE 1031 EXCHANGE
In a reverse exchange, the replacement property is purchased before the sale of the relinquished property is completed. You must notify the qualified intermediary which
property you intend to sell. The notificaiton must be in writing, signed, and delivered within the 45-day notification period (explained below). In a very strong seller's market, this is a reasonable tactic. In any other market,
you need a much stronger understanding of the Absorption Rate and Demand Ratios in the area of your relinquished property. With that knowledge, you will have a clear understanding of
how long it will take to sell your relinquished property based on how you price and market the property, and therefore, if a reverse 1031 can succeed.
A reverse exchange is best used in a very strong seller's market.
Unless you have financing lined-up with a lender agreeing to work with you based on your intent to utilize the 1031 exchange, you will likely need to acquire the property with cash through a Qualified Intermediary
(explained elsewhere), using an Exchange Accommodation Titleholder (typically the QI).
If you have an existing mortgage on the property that you intend to sell (aka the Relinquished Property), your lender will need to
configure your new mortgage to match the dollar value or greater of the existing mortgage. If you obtain a new mortgage for less than the existing mortgage, you will be subject to capital gains tax on the reduced
portion of the mortgage (explained elsewhere). Plus, you will now be carrying two mortgages until such time as you sell the relinquished property.
After the replacement property is purchased, you then have 45-days to identify the relinquished property (the property you are going to sell), and a total of 180-days which includes the 45-day identification
period to close on the sale of your relinquished property. The 180-days includes the 45-days as in: 45 days + 135 days = 180 days.
1031 EXCHANGE RULES
Typically, you will need a qualified intermediary (an arms-length middleman who holds the proceeds from the sale of your property.)
The intermediary then uses your money that he/she is holding to “buy” the replacement property for you. This three-party exchange is the swap exchange.
TIMELINES THAT MUST BE ACHIEVED
45-DAY RULE:
After your property sells, the intermediary will receive the funds, NOT YOU. You are not allowed to receive the cash. If you do, the 1031 exchange will be disallowed. You now owe the capital gains tax as though no 1031 Exchange was attempted. Within 45 days of the sale of your property, you must identify up to 3 properties that will serve as the potential replacement properties and notify the intermediary in writing. You must close on one of the selected properties withing 180-days.
180-DAY RULE:
You must close on the Replacement Property within 180-days of the sale of your Relinquished Propeerty (Sold property). If you don't close within the prescribed timelines, the 1031 exchange will be dissallowed.
TIMELINES RUN CONCURRENTLY (at the same time):
The 45-day identification of the replacement property and the 180-day acquisition periods run at the same time. You start counting when the sale of your property closes. If you designate a replacement property on the 45th day after the sale of your property, you’ll have 135 days left to close on the identified replacement property (45 + 135 = 180-days).
HOW TO QUALIFY VACATION HOMES:
If you rent out your vacation house and follow the personal usage rules/usage timeframes, and treat the vacation home like a business (pay taxes on the rent and keep records etc.), then you can qualify your vacation home as an
investment property.
You must rent your house to another person for a fair market price for 14-days or more.
Your personal use of the house cannot exceed 14 days or 10% of the number of days during the 12-month period that the house is rented at a fair market price, whichever it greater (14-Days or 10% of the rented days).
1031 exchanges apply to real property held for investment purposes. A vacation investment home will likely be dissallowed by the IRS for a 1031 exchange unless it is rented out.
DEPRECIATION RECAPTURE with the 1031 EXCHANGE:
As an investor, you are almost certainly depreciating your investment properties. The 1031 exchange will defer the depreciation recapture. Speak with your accountant to find out how this benefits your particular situation.
DEFINITION OF REAL PROPERTY UNDER SECTION 1031
Internal Revenue Service:
Real Property includes land and generally anything permanently built on or attached to land. In general, real property also includes property that is
characterized as real property under applicable State or local law. In addition, certain intangible property, such as leaseholds or easements, qualifies as real property under section 1031.
Property not eligible for like-kind exchange treatment prior to enactment of the TCJA remains ineligible.
Neither the TCJA nor the final regulations change whether the properties exchanged are of like kind.
LINK: Definition of Real Property by
the Treasury and the IRS under section 1031
FORM 8824:
You must notify the IRS of the 1031 exchange by submitting Form 8824 with your tax return in the year when the exchange occurs.
Here's a link to the page that has the current form 8824:
https://www.irs.gov/forms-pubs/about-form-8824
WHEN NOT TO DO A 1031 EXCHANGE:
- When you're selling at a loss
The exception is if it is more advanatgous to carry the Loss through a 1031 replacement property.
- For the sake of it as in, when the purchase of the replacement property is a bad deal
- When it makes more sense to pull cash out by refinancing your investment properties. Your financial advisor might suggest refinancing the replacement property instead of the relinquished property.
If you know that you're going to do a 1031 but want cash, you need to plan far ahead to avoid potential tax challenges to the 1031.
The exception is if it is more advanatgous to carry the Loss through a 1031 replacement property.
LANGUAGE OF THE 1031 EXCHANGE
| TERMINOLOGY | MEANING: |
|---|---|
| 3 Property Rule (Limitation Rule) | You can identify up to 3 replacement properties within the 45-day statement period. |
| 200% Limitation Rule |
You can identify as many replacement properties that you choose as long as the combined fair market value of the identified replacement properties remain within 200% of the fair market value of your relinquished property. |
| 95% Rule that you'll never use! (Limitation Rule) | You can identify as many replacement properties with a fair market value over 200% as long as you then acquire 95% of the fair market value of the identified replacement properties. If you don't close on 95% of the value of the identified replacement properties, the 1031 Exchange will be disallowed and you will need to pay the capital gains tax as through the exchange was not attempted. |
| 45-Day Rule (General) | You have 45-days to identify the replacement property or properties. You must provide written signed notice identifying the replacement properties in detail within
the 45-day period. You must notify a key person within the 1031 transaction, generally this would be the Qualified Intermediary but it can also be
the escrow agent or title company. The more detail the better. Include the street address (if assigned), parcel number, legal desription (if unknown, you can have your real estate
agent or other professional help you get this information), and any other identifying information. Many land parcels are not assigned a street address until a permit is pulled for construction.
Many people with various titles DO NOT satisfy the notification requirement. As an example, while you should keep your real estate agent in the loop, notification sent to your agent does not satisfy the requirement. |
| 45-Day Rule with acquisition |
If you purchase a property during the 45-day identification period as part of the 1031 Exchange Code and plan on buying additional properties that you have identified, you are still working within all applicable rules. Therefore, the property acquired within the first 45-days counts toward the limitation rules. |
| 180-Day Rule | From the date that your relinquished property closes, you have 180-days to complete all aspects of the 1031 requirements. |
| BOOT | Boot is essentially, anything that is not deferred. It also includes reduction of mortgage debt.
Boot is not always bad. You may want to take some cash for whatever reason, but it can also occur unintentially. Example: Boot can occur if any portion of the sales proceeds are not reinvested into the replacement property. If you traded down, you might end out with cash. If you sell your relinquished property and have the closing agent slice off $20K for yourself, that $20K is subject to the capital gains tax. Mortgage Boot occurs when your replacement property reduces your mortgage. As an example, if you trade down, you may end out with a lower mortgage. Any reduction in the mortgage amount will be subject to tax. You can offset the mortgage reduction with funds that you bring into the transaction. Here's a simplified example: You sell your relinquished property for $500,000. You had a remaining mortgage of $200,000. This leaves you with net equity of $300,000. To avoid capital gains, your replacement property should be $500K made up of an equal amount of the prior equity and debt. Any cash that you don't reinvest will be taxable. Any reduction in your mortgage debt is subject to capital gains tax. However, you can offset the mortgage reduction by investing new funds to offset the debt requirement aspect of the exchange. If you over-mortgage the replacement property, the QI may end out with remaining cash which becomes Boot. |
| CODE 1031 | Under Internal Revenue Code 1031, capital gains tax is deferred. No gain or loss is recognized in the transaction. |
| Drop and Swap | A complex method in which a partner or partners in an LLC want to cash out while other members want to continue. |
| EAT | EAT is the abbreviation for Exchange Accommodation Titleholder |
| Exchange Accommodation Titleholder (EAT) | An intermediary who holds the Title of the relinquished or purchased property (in the case of a reverse 1031), while the other 1/2 of the transaction is finalized.
Neither you nor anyone who is disqualified from recieving notification of your selected replacement properties can act as an EAT. |
| Exchangor | Although you are the exchangor, when you enter into an agreement with a QI (qualified intermediary), the QI assumes your role so that no violation of the 1031 rules take place. |
| Like-Kind | Real Estate allows for a wide range variation of Like-Kind definitions. A house for a house or 3 houses for a multi-family etc. If you are planning on exchanging your real estate investment property for a different type of real estate investment property, you will probably be able to do so but, check with whoever you end out hiring as your qualified intermediary. |
| PARKED PROPERTY | Your relinquished or replacement property held by the Exchange Accomodation Titleholder (EAT), usually in an LLC., based on the Terms in the Qualified Exchange Accomodation Arrangement/Agreement (QEAA) |
| Qualified Intermediary aka Accomadator | An independent third party who is by agreement, allowed to sell your property, collect the funds from that sale, and then use those funds to acquire a replacement property for you. Direct swaps are possible but rare which is why a qualified intermediary is needed to achieve a successful 1031 Exchange. Qualified Intermediary aka QI |
| Qualified Exchange Accommodation Arrangement (QEAA) | An agreement/arrangement in which a third party holds title to the relinquished or replaement property. |
| Reverse Exchange | In a reverse exchange, the replacement property is purchased before the sale of relinquished property is completed. |
| Relinquished Property | The property you are selling or have sold |
| Relinquished Property Identification Statement | In a reverse 1031 Exchange, you have 45-days to indentify which investment property you are selling. You must notify a key person involved in the exchange. |
| Replacement Property | The property you are buying or purchased |
| Safe Harbor Period | The two key timelines that run concurrently which are the 45-day identification period and 180-day closing period, both of which start on the day the Exchange Accommodation Titleholder (aka EAT) closes on the replacement property. |
| Starker Exchange | Another name for the 1031 Exchange. |
| Starker Case Info |
For anyone who enjoys legal history, Google Scholars has an excellent write-up on Starker vs U.S. which an be found here: T. J. STARKER, Appellant, v. UNITED STATES of America, Appellee PDF COPY OF STARKER APPELLANT CLICK FOR HOW STARKER VS U.S. WAS CITED PDF COPY OF HOW STARKER VS U.S. WAS CITED |
| Swap Exchange | Typically a three-party exchange involving a Qualified Intermediary, seller and buyer. It is possible to do a swap exchange without a QI if you are able to schedule a simultaneous closing of your relinquished property with the replacement property. Make sure that you speak with your accountant and that he/she is familiar with the 1031 code before attempting a swap on your own. |
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DISCLAIMER
The writer of this article is a Real Estate Broker not an attorney or an accountant. This article is for information purposes. It is a starting point for your further research on the 1031 exchange subject. We believed the information is accurate but we do not guarantee its accuracy. Whenever someone has a legal or tax question, you must consult with your own legal and tax professionals for qualified information. The author is not qualified to offer legal or tax opinions or advise. The information provided is for general knowledge purposes but should not be relied on without confirming with your other professional service providers.
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