Everything You Need to Know About 1031 Exchanges

1031 Exchanges

Investing in real estate can be complicated for novice and experienced investors alike. From the hassles of landlord duties to navigating regional or national economic downturns, there are many ways investors can be tripped up.

This is especially true when selling an investment property -- capital gains and other taxes can take a big bite of your proceeds if you don’t have a plan in place to shelter your gains. You can, however, divest an investment property and defer capital gains taxes if you do a 1031 exchange.

This article provides a deep dive into the 1031 exchange process. Investors have used this tool for decades to help manage tax liabilities by reinvesting proceeds from the sale of investment properties into like-kind assets. We’ll look at how the exchange process works, why you should consider using it, potential benefits and drawbacks, costs associated with 1031 exchanges, and more.

What is a 1031 Exchange and Why Use It?

A 1031 exchange allows real estate investors to sell or “relinquish” investment properties and roll the proceeds into like-kind replacement assets. There are many reasons why this investment vehicle could prove beneficial when selling an investment property, including:

• Deferral of federal and state capital gains, depreciation recapture, and Affordable Care Act taxes
• Increased portfolio diversification through multiple replacement properties

The name 1031 exchange comes from Title 26, Section 1031 of the Internal Revenue Code. The IRS first allowed farmers to exchange land in 1921, but today’s exchanges are limited to real property assets purchased and held for investment purposes.

Investors can use 1031 exchanges to defer tax liabilities indefinitely so long as they keep reinvesting capital back into real property. You can keep swapping properties until you die, whereupon you can bequeath your interests to your heirs, who will receive a one-time step-up in basis that can potentially eliminate all those rolled-over tax liabilities. However, if you sell an asset purchased through a 1031 exchange without reinvesting the proceeds, you’ll face the tax liabilities listed above, as well as any taxes you may have owed through previous 1031 exchanges.

In addition to deferring taxes, investors often complete 1031 exchanges to create increased portfolio diversification and potentially mitigate risk by purchasing investment properties in different asset classes and geographical regions. Others who exchange are seeking to upgrade their investment properties or are shifting their investment strategies to different assets.

6 Steps to Completing a 1031 Exchange

There are some key deadlines you need to meet in order to successfully complete a 1031 exchange. While this section provides a walkthrough of the exchange process, it’s always a good idea to consult with experienced tax and legal professionals prior to beginning an exchange to ensure you meet your investing expectations, IRS deadlines and avoid potential pitfalls.

Step 1: Plan ahead

Due to the deadlines involved with 1031 exchanges, it’s important that investors strategize prior to relinquishing an investing property. Start by thinking about the types of replacement assets that best meet your investment goals while meeting the “like-kind” definition required by the IRS. Many regions of the U.S. have red-hot real estate markets, so it could be even more difficult to find like-kind assets in these areas. Getting the pieces in play before selling (relinquishing) is crucial to ensuring a successful exchange.

Step 2: Assemble an exchange deal team

It’s likely you already have an accountancy and tax professional in place. You’ll also need to engage a third-party Qualified Intermediary (QI) to complete a 1031 exchange since investors aren’t allowed to handle any proceeds from the sale of their relinquished assets.

QIs, also called Exchange Accommodators, fulfill several important duties. They acquire relinquished properties from exchangers and transfer title to buyers. They also acquire replacement assets from sellers and transfer title to exchangers. In between, they’ll handle all the documentation required to complete the exchange.

Since Qualified Intermediaries also hold all proceeds from the sale of relinquished assets in escrow until they are needed to purchase like-kind replacements -- it’s important to choose a carefully vetted QI to avoid the potential for malfeasance.

Step 3: Identify replacement properties

Replacement properties must be similar in character or investment-grade as the asset you are selling. Exchangers have 45 calendar days to identify up to three replacements assets after the close of sale on their relinquished properties. You can identify more than three properties if the cumulative value doesn’t exceed 200 percent of your relinquished asset’s sale price.

Step 4. Line up acquisition financing

When paying off the debt on your relinquished property, you typically want to replace it with a similar debt load for the replacement asset. Make sure you have the ability to secure financing or capital equity to complete the exchange on time. Since you only have 180 days to complete the exchange after selling your relinquished property, it’s important to make sure this piece of the puzzle fits before beginning the exchange process.

Step 5: Sign a contract and let your QI get to work

Once you get a replacement asset under contract and in escrow, your QI begins the legwork of completing the paperwork needed to satisfy exchange requirements.

Step 6. Close on the replacement asset

Once the deal closes, the QI wires funds to the title company, just like any straightforward real estate transaction. To reiterate, you must close on your replacement asset within 180 days after the close of sale on your relinquished property.

Risks Associated With 1031 Exchanges

Completing a 1031 exchange definitely isn’t without risk. Following the rules to the letter can help ensure a successful exchange.

We’ve identified three primary risks that could potentially hang you up and disqualify your 1031 exchange -- and then you’ll be on the hook for paying capital gains and other taxes on the sale of your investment property.

Risk 1: 45-day deadline

The IRS stipulates that replacement assets must be like-kind to relinquished assets. You only have 45 days to find up to three replacements, and they must be of similar investment grade as the asset you relinquished. In markets where good deals are snapped up as soon as they are listed, you could potentially find yourself without a suitable replacement. Starting your search well before selling your current investment property provides an important time cushion, as well as more time to properly conduct due diligence on prospective properties.

Risk 2: 180-day deadline

While there has been some flexibility on this deadline due to the impacts of COVID-19, you’d do well to consider this timeframe set in stone. Failure to close on a replacement asset within 180 days after selling a relinquished asset likely will disqualify your exchange. Line up professional help and financing, if applicable, well in advance to help ensure a smooth exchange.

Risk 3: Your Choice of QI

Choosing a savvy QI can make the exchange process go off without a hitch. Since this person is basically buying a replacement asset and selling a relinquished one on your behalf, it’s crucial to choose one that works responsibly and professionally.

In addition to holding your funds, Qualified Intermediaries prepare and execute all the documentation required to complete an arm’s length transaction between the seller and exchanger. And since this industry is not federally regulated, it can leave the door open for malfeasance. Seek references when choosing a QI to facilitate your exchange.

QI Fees for 1031 Exchanges

After you’ve found a trusted Qualified Intermediary, it helps to know how much they’ll charge for their services. Fees for a 1031 exchange vary depending on how much work your QI does to complete the process and whether you're using an institutional QI that’s a subsidiary of a bank or title insurance firm or an independent.

QI’s typically charge administrative and setup fees on the sale of relinquished properties and replacement assets. For institutional QIs, these costs can run between $800 and $1,200. Independent QIs, meanwhile, typically charge around $600 to $800 for these services.

QIs usually earn much more than that through the interest generated as they hold your proceeds, however. Institutional QIs typically receive a lower percentage of interest income since they charge more for initial setup, while the opposite is true for independent QIs.

Pros of a 1031 Exchange

Now that we’ve outlined how the process works, let’s take a look at the primary benefits of completing a 1031 exchange.

Deferring capital gains and other taxes

Capital gains isn’t the only tax you’ll face if you sell an investment property without rolling the proceeds into a 1031 exchange. You may have to pay depreciation recapture, state capital gains and Affordable Care Act taxes as well. These taxes could erode as much as 35 percent of your profits. Completing a 1031 exchange allows you to defer payment on every one of these tax liabilities.

The potential for increased cash flow

Say you’ve held a rental property for a decade and realized significant asset appreciation. Rather than paying the IRS a hefty chunk of your proceeds from sale of that investment property, you can roll the entire amount into a 1031 exchange property of greater value that could potentially generate higher annual returns than your original asset.

Acquiring new assets

You can exchange into progressively larger assets, allowing you to potentially increase the value of your commercial assets over time. When you die, you can bequeath these assets to your heirs, who can receive a one-time step-up in basis that could allow them to divest the assets without paying any of the deferred capital gains and depreciation recapture taxes.

Cons of a 1031 Exchange

Despite the many potential benefits, there can be some drawbacks to 1031 exchanges as well. These include:

Taxes are only deferred

A 1031 delays rather than eliminates capital gains taxes. If you sell your exchange property without completing another exchange, you’ll be on the hook for those deferred taxes and any depreciation you’ve claimed.

Strict IRS regulations

The exchange process adheres to stringent IRS guidelines -- here’s where you’ll be leaning on the expertise of your Qualified Intermediary.

In addition to the crucial 45- and 180-day timelines, your replacement property must have a value and mortgage balance that’s greater than or at least equal to your relinquished asset.

Reduction in basis for depreciation

Depreciation in a 1031 exchange replacement property is based on the adjusted basis of your relinquished asset, which typically is lower than what you would receive if you would have purchased the asset by other means.

1031 Exchange Taxable vs. Non-Taxable Selling Expenses

Although capital gains taxes from your 1031 exchange are deferred, some expenses paid from the proceeds of the exchange can generate a taxable event. Operating costs and standard financing fees that are paid from your proceeds will generate a taxable event, while normal selling expenses won’t.

Below is a closer look at the selling expenses which could result in taxable boot, or the cash difference one party pays to make the deal equal on both sides in order to satisfy the like-kind requirement in value.

Routine transactional expenses

The majority of closing fees are transactional expenses related to divestiture of your relinquished asset or purchase of the exchange property. The following costs related to these events don’t generate a taxable event:

• QI fees
• Attorney and tax advisor fees
• Broker commissions
• Title insurance premiums
• Inspections for exchanged properties and surveys
• Recording and filing fees
• Escrow agent and settlement agent fees

Loan acquisition costs aren’t listed here for several reasons. When those fees are paid from proceeds, they create taxable boot because they aren’t part of acquiring the replacement property; instead, they are viewed as costs tied to obtaining a loan instead of direct costs associated with acquiring the exchange asset. Loan fees can include appraisals, title insurance, points, and assumption fees. If you can avoid using sale proceeds for these expenses, then you won’t create a taxable event.

Standard operating fees

Operating costs, which typically include maintenance expenses, security deposits, and prorated rents and property taxes, aren’t directly associated with the acquisition of replacement assets and can create a taxable event. Oftentimes, exchangers provide credits to the buyer to help offset closing expenses or repairs. Credits can be paid from sale proceeds, so the exchanger realizes a lower sale price and avoids taxable boot.

Financing and operating costs can be a difficult area to navigate correctly during a 1031 exchange. Discussing these costs with a tax professional can help create the most efficiently taxed exchange.

What is a Partial 1031 Exchange?

It’s possible to do a 1031 exchange and keep some of the proceeds from your relinquished asset to use however you see fit. Instead of reinvesting the entire amount received from the sale of your investment property, you can do a partial 1031 exchange.

Any proceeds you don’t reinvest are taxable boot -- you’ll owe capital gains and depreciation recapture taxes on this amount. There are two different types of taxable boot:

• Cash

  These are the proceeds from your relinquished asset that you don’t reinvest.

• Mortgage

  This is a reduction in mortgage liabilities between your replacement asset and what you owed on the relinquished asset.

When doing a partial 1031 exchange, you’ll follow the rules and deadlines of a standard exchange; however, you’ll request a portion of sale proceeds at close of sale on your relinquished asset. Typically, a Qualified Intermediary holds all the proceeds and distributes any excess cash after meeting equity requirements and closing on the replacement asset.

Benefits of a partial 1031 exchange

One reason some investors choose this route is to receive some of the funds from the exchange. You can use the money to pay down personal debt, take a vacation, or any other reason you see fit -- there are no restrictions. Monies received from the sale of your relinquished asset will be taxed at your personal income tax rate.

You also can do a partial 1031 exchange to reduce debt on your replacement asset. If your relinquished asset sells for $500,000 and has a $30,000 mortgage, you can exchange the $500,000 into the replacement property and generate a taxable event on the $30,000 boot.

Drawbacks to partial exchanges

The decision to do a partial exchange lies in your basis and depreciation -- there’s little to no benefit if the boot is the same as or more than the capital you receive from the relinquished asset. Conversely, your tax liability from a partial exchange could negate any potential benefits if the boot amount is too large.

A partial 1031 exchange can be more complicated than a standard exchange, so it’s important to consult with your accountant and tax professional to understand the potential benefits and pitfalls of this type of exchange.

Conclusion

A 1031 exchange should be viewed as a long-term investment strategy since your funds will be tied up in commercial real estate that you can’t liquidate quickly without creating a significant tax liability.

Exchanges can be completed across state lines, so it’s important to know the tax treatments and policies of the different states where prospective replacement assets are located. And since there are time limits to complete a 1031 exchange, it’s prudent to line up potential replacement assets before selling your original property.

There are many reasons why investors opt for a 1031 exchange. Discussing your investment goals with informed professionals can help you decide if this is the appropriate tool for your investment philosophies.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

This information does not constitute tax or legal advice. Consult with an appropriate professional regarding your individual tax circumstances.

The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.