Section 1031 of the Internal Revenue Code
The owner of real property can sell that property and then reinvest the proceeds in a “like-kind” property and defer paying any capital gains taxes. To qualify as “like-kind,” the exchange must be done according to the rules in the tax code; it does not mean you have to replace an apartment building with an apartment building, etc.
Investors can reap significant tax benefits by taking advantage of the 1031 exchange, and in some areas, it’s considered one of the best-kept secrets in the Internal Revenue Code. A properly structured exchange can provide investors with the opportunity to defer all of their capital gains taxes. This results in an essentially interest-free, no-term loan from the government. Instead of paying the taxes now, the investor can put those dollars to work on other investment properties.
To qualify the investment must be held for investment or business purposes.
Proceeds from the sale must be passed through the hands of a qualified intermediary and must not be received directly by the investor, or they will become taxable.
All proceeds must be reinvested; any cash proceeds retained will be taxable. If you are curious about your potential proceeds, be sure to check out our 1031 Exchange Proceeds Calculator.
The replacement property must involve an equal or greater level of debt than the relinquished property (if not, the investor will have to either pay taxes on the difference or put in additional cash funds to offset the lower level of debt in the replacement property).
Foreign investors may also participate in the 1031 tax exchange and are subject to the same rules of qualification.
An investor can’t defer capital gains taxes on a warehouse by purchasing a family home in which the investor intends to live. However, investors can defer gains on personal property, such as equipment, provided they buy other equipment as the exchange vehicle. Investors can exchange property that’s residential, commercial, industrial, or even leased property if the lease is for 30 years or more and includes ownership interest. Investors can exchange into vacant land, hotels, motels, etc., provided the exchange meets certain IRS rules.
IRS 1031 Exchange Rules.
First, there’s the like-kind rule, which we’ve already discussed.
Second, the basis of the original property carries over to the new property. It doesn’t change. So if your investor has a property worth $500,000 with a basis of $100,000, and then exchanges it for a property also worth $500,000, the basis in the new property is $100,000, plus any new debt taken on and any cash paid out.
The Third rule is that the new property has to come with the same or greater debt load for the investor. If it doesn’t, the investor will be liable for the gains on the difference. The IRS doesn’t want the investor pocketing any change on gains realized—this is simply a way to defer gains from one property by investing those gains in another. To be clear, any cash your investor receives from the proceeds of the sale is taxable. It’s called boot. It doesn’t mean there can’t be a tax-deferred exchange, but the taxes on the boot are due and payable.
The Fourth rule is that the investor must use a third party called a qualified intermediary to conduct the exchange. In short, your clients can’t do the exchange for themselves. And if they’ve worked with the investor in the past two years, neither can the investor’s attorney, CPA, or real estate broker. The qualified intermediary will coordinate the exchange between the parties and their attorneys or agents, coordinate documents and money transfers through escrow, and submit a 1099 to the taxpayer and the IRS for proceeds paid.
The Fifth rule is that the investor has only 45 days (including weekends) from the day of closing on one property to identify and commit in writing to the next property, and 180 days from the date of sale of Property #1 to close on Property #2. These are firm dates, and there is only one way to extend those dates: The President of the United States has to declare a natural disaster area that affects the properties or parties involved. Seriously
Pro Tip: If you change your mind about the property in the middle of the exchange, your tax deferral may be in jeopardy due to the deadlines involved. If your change of heart occurs during the 45-day identification period, and you haven’t yet closed on the sale of the property being sold, ask for an extension from the other party.
Hopefully, though, you’ve identified a backup property, just in case. If so, extricate yourself from the first transaction and quickly get the other in writing within that 45-day window. This formal identification has to be made, in writing, with the QI through fax, mail, or courier. Once the 45 days is up, that’s it. Revoking and submitting a new property for exchange will not reset the deadline.
The Sixth rule is the 1031 must be disclosed to the buyer. At the time of the sale and at the time of the purchase, you have to tell the parties to the transactions that you’re doing a like-kind exchange. Most contracts in the State of Florida have a 1031 Exchange Clause built right into the contract.
Details About Deadlines
Let’s say you fail to identify a property in 45 days, or the deal falls apart and you can’t cobble another one together within that 45 days. It's not the end of the world, but it is the end of your chance to do a 1031 for that deal.
The 180 days is also firm unless the deadline becomes shorter. The rule is that you have to complete the 1031 exchange by the earlier of either midnight of the 180th calendar day following the close of Property #1 or the due date of your client’s federal income tax return for the tax year in which the relinquished property was sold, including any extensions. This only becomes a problem if Property #1 is sold between October 17 and December 31 of any given tax year, because that would mean that the 180th calendar day would fall after April 15, tax day.
1031 Exchange Options
There are three more rules you should be aware of related to the identification of the replacement property:
200% rule: Exchanging into multiple properties is okay, but their combined value may not exceed 200% of the value of the relinquished property.
Example: You have a property worth $100,000 and finds 18 properties to exchange into. This is permissible, as long as those properties’ total value isn’t more than $200,000.
95% rule: Exchanging into multiple properties is okay, as long as their combined value totals at least 95% of the value of the relinquished property.
Example: You have a property worth $1 million and identify six properties with a total value of $950,000.
Three-property rule: Exchanging into as many as three properties is okay with no fair market value restrictions (as long as the debt-load requirement is met). Most investors opt for this approach, since the 200% and 95% rules can be confusing.
If you find and close on an investment property and then decide to sell another property, you can do a tax deferral “backward.” This is called a reverse exchange. You’re still strapped to the 45- and 180-day deadlines, though, and it can get complicated.