Introduction to Real Estate Section 1031: The Basics of Tax Deferred Exchanges

Section 1031: The Basics of Tax Deferred Exchanges

Intro: Did you know you can exchange appreciated real property for another piece of real estate and pay no current income taxes? A Section 1031 Exchange enables the entire increased value to be tax–deferred.

Property owners can defer capital gains taxes on the equity in their property by using Internal Revenue Code Section 1031. Known commonly as a “1031 exchange option,” this application of the tax code is one of few provisions available to postpone or potentially eliminate taxes due from the sale of qualifying properties.

As a property owner, you may also achieve a wide range of investment objectives by using a 1031 exchange. You can diversify your real estate investment portfolio, consolidate your real estate holdings in a single larger property, and possibly improve your cash flow from your real estate investments.

What qualifies as a Section 1031 Exchange?
Section 1031 states that no gain or loss shall be recognized on the exchange of any real property when the property owner trades one or more properties for a replacement property or properties that are of "like-kind.” Like-kind means any real estate, improved or unimproved, that the owner uses for income, investment, or business.

That means you can exchange one property for two or more properties, or trade two or more properties for one replacement property. You can trade land or several single-family homes for an apartment building. Investment property can be exchanged for business property and vice versa.

One stipulation is that the property to be exchanged and the like-kind replacement property must both be located in the United States. Also, under the rules of IRS Section 1031, you cannot exchange your personal residence for income property, and you cannot exchange income or investment property for a personal residence.

The rules of tax deferral
In a Section 1031 Exchange, the tax on the equity in the property — the value of the property over the original purchase price — is deferred. The property you relinquish must be exchanged for other property; you can’t sell the property for cash then use the cash to purchase replacement property.

In a “like-kind” exchange, tax is deferred, not eliminated. You reinvest what would be the sales proceeds into another property; therefore, your gain isn’t realized in a way that generates funds to pay any tax.

The four basic rules for a property owner to qualify for a tax deferral on all the taxable gains under the 1031 rules are:

1. The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
2. The value of the replacement property must be equal to or greater than the value of the relinquished property.
3. The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
4. All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.

The 3 types of 1031 Exchanges
The Section 1031 Exchange type depends largely on the time involved. For example:
1. In a Simultaneous Exchange, you would exchange your relinquished property for your replacement property at the same time, closing both transactions simultaneously.
2. In an Improvement Exchange, you are allowed to make improvements to a replacement property before the exchange is made. This type of exchange is facilitated through a third party, called an Exchange Accommodation Titleholder (EAT). The EAT holds title to the new property while the improvements are being completed. Once you take title, you cannot include money spent on any more improvements as part of the exchange value.
3. In a Delayed Exchange, there is a time gap between the transfer of the relinquished property and the acquisition of the replacement property. The IRS has very strict time limits on delayed exchanges and you must comply with the requirements. This type of exchange is facilitated through the use of a third party, called a “qualified intermediary.” The intermediary holds the proceeds from the initial exchange until the replacement property, which meets the like-kind specifications, is identified and purchased.

A qualified intermediary is an essential member of your team when working on a successful exchange. An intermediary cannot be the property owner or any “disqualified person” (which is defined as those people who have represented or served you in their professional capacities within the previous two years). A disqualified person would include your accountant, attorney, or real estate agent.

Under the IRS code, there are no formal licensing requirements for qualified intermediaries. But they may need to be licensed as an escrow firm by the state in which they practice.

The rules for the exchange
The Internal Revenue Code outlines in great detail the time restrictions on completing a Section 1031 Exchange. You have 45 days after the date the relinquished property is transferred to properly identify potential replacement properties. The exchange must be completed within 180 days after the transfer of the relinquished property or before your federal tax return due date for the year in which you transfer your relinquished property, whichever is earlier.

If you fail to meet the Section 1031 time limits, the tax-deferred exchange will fail, and you will have to pay any taxes arising from the sale of the relinquished property. The IRS may grant an extension in only one instance: if the transaction closing is delayed by a U.S. government federally designated disaster, such as a hurricane or earthquake.

Section 1031 Exchanges have three specific and inflexible rules that limit the number of properties you can identify for exchanges. You must meet the requirements of at least one of these three rules:
1. The three-property rule: You may identify up to three potential replacement properties, without regard to value.
2. The 200 percent of value rule: You may identify any number of properties, but their total value cannot exceed twice the value of the relinquished property.
3. The 95 percent of fair market value rule: You may identify as many replacement properties as you want, but before the end of the exchange period, you must acquire properties with total fair market value equal to at least 95 percent of the aggregate fair market value of all the identified properties. In other words, if you identify 20 properties at $1 million each for a total value of $20 million, you must acquire 19 of those properties at $19 million, to satisfy the 95 percent requirement.

ALWAYS FIRST CONSULT A HIGHLY QUALIFIED REAL ESTATE TAX PROFESSIONAL!!!
As the taxpayer, you must comply with the rules, conditions, and timeframes in the IRS Code, as provided in Section 1031. It is highly recommended that you consult a competent tax attorney, a certified public accountant, a “qualified intermediary,” or a well-qualified tax advisor who specializes in real estate to determine how a 1031 exchange should be structured to accomplish your investment objectives with minimum taxation.

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