1031 exchanges remain a popular investment route for those who want to defer capital gains taxes. Since you can indefinitely continue the process, you delay tax payments if you grow your initial capital. While this potential is appealing, the IRS has strict 1031 exchange rules and stipulations to help prevent abuse and ensure the tax-deferred status of investors and property owners.
Understanding like-kind exchange rules and requirements is critical to ensure a smooth process on the investor’s end. Following these requirements also lowers the chances of penalties or disqualification from the tax deferral benefit.
Realized 1031 is here to share an expansive guide about everything you need to know. Keep reading to learn more about the intricacies of each rule.
The 1031 exchange is also called the like-kind swap. Based on this alternative name, the “like-kind” requirement is a core rule of the transaction. To qualify, both the relinquished property (asset you want to sell) and the replacement property (asset you want to acquire) must be like-kind. In other words, the properties must be of the same nature, character, or class. As such, the grade or quality of the properties does not matter.
As per the IRS, here’s what qualifies as like-kind property.
Real estate property outside the U.S. doesn’t qualify for a like-kind swap. In addition, personal property within a relinquished real estate asset will not qualify since it is not part of the property itself. This includes furniture, artwork, and machinery. If you sold a commercial building and part of the proceeds include equipment sales, then that portion of the profit will be considered boot and is taxable.
Assets that aren’t considered real property cannot be exchanged either. These include stocks, bonds, and mutual funds.
There is a common misconception that investors can only exchange properties of the same type. The vagueness of the “like-kind” label often leads to this unsurprising confusion. Investors may think that they can only exchange an apartment complex for another apartment complex. However, as mentioned, the like-kind requirement doesn’t depend on property types. As such, you can exchange the apartment complex for a strip mall or an industrial warehouse. Even though each option has vastly different functions than the apartment complex, they’re still real estate investments. This flexibility allows investors to diversify their portfolios while enjoying tax-deferred status.
All real property qualifies for a 1031 exchange as the first rule implies. However, this next one adds one more restriction to what you can swap. The IRS also limits the type of real estate asset to only ones that are used for investment or business purposes. This is also called the qualified use requirement. As such, ownership intent is key for these transactions. The real estate assets you hold for personal use wouldn’t qualify for an exchange. In other words, your primary residence, even though it’s considered a real property, is not allowed for a 1031 exchange.
What is qualified as business or investment property? Here are a few examples.
It’s not just primary residences that get disqualified based on these descriptions. Flipped properties are also not acceptable for 1031 exchanges. This is because these properties are bought with the intent to sell and not invest. In this case, they are considered inventory instead of investments.
How do you prove your intent to hold a property for investment or business purposes? The IRS may scrutinize an exchange based on this requirement, making it critical for you to prove your intentions and maintain your tax-deferred status. Certain types of exchanges are more prone to further evaluation by the IRS. For example, if you bought a property but held it for only six months, you may find it hard to prove that your intent is a long-term investment.
There are a few things you can do to clarify your intent. One of the surest ways is to hold on to the property you intend to relinquish for a longer time. This practice may help prove that you’re holding the real estate asset for investment use. We also recommend maintaining records of rental income, business expenses, and lease agreements. These documents also show proof that you held the property for investment or business use.
The 1031 exchange timeline rules are another set of stipulations that investors must adhere to to maintain their tax-deferred status. The IRS set up these deadlines to ensure a timely exchange process and avoid indefinite tax deferral. What are these deadlines exactly? These are the 45-day identification period and the 180-day exchange period.
Immediately after you sell the relinquished property, you have 45 days to identify a number of replacement properties. The first day begins on the day the sale closes. You will need to work with your qualified intermediary to document these properties. That’s because the IRS will require you to submit documents with details about the properties to your qualified intermediary.
Let’s say that you were able to close the sale on March 1st. You have until April 15 to provide the full list of replacement properties. Missing the deadline or submitting an incomplete list will result in the loss of your tax-deferred status. As such, it’s the best practice to begin scouting properties well before you sell your relinquished property. Having a shortlist will also help you avoid last-minute decisions.
The IRS has certain rules on the maximum value and number of properties you can include on the list. We will discuss these specific rules later.
The entirety of the 1031 exchange must happen within a 180-day timeframe. The 45-day period also falls within this deadline. As such, you only have 135 days after you close the relinquished property’s sale to finish the rest of the transaction.
For investors, this timeframe can be too quick. There are plenty of problems that could delay the acquisition of the new property. For one, finding a qualifying replacement property and closing the sale can be challenging in competitive real estate markets. You may also experience delays in securing financing.
Another challenge brought about by the 180-day rule is overlapping tax filing deadlines. If the exchange occurs late in the tax year, then there’s a chance that you may need to file an extension for your tax return or finish the transaction earlier than 180 days. Let’s say that you were able to sell your relinquished property on December 1. The 180-day deadline comes on May 30 the following year. Given that the federal deadline for tax filing is on April 15, then you will need to file for an extension to remain compliant.
We want to emphasize again that the IRS is strict and unforgiving when it comes to these deadlines. Missing any one of them will result in the loss of your tax-deferred status and immediate tax liability. As such, we recommend practicing the following strategies to improve your chances of success.
The 1031 exchange identification rules govern how many properties you can identify or up to what value. Thanks to these rules, the process of selecting potential replacement properties during the 45-day identification period is much clearer. Again, failing to follow these rules may result in your disqualification, so make sure to comply.
In most traditional 1031 exchanges, investors follow the three-property rule. As the name suggests, this stipulation limits the number of properties you can submit to your qualified intermediary to up to three properties. The total value of these three properties doesn’t matter. Let’s say that you relinquished a $1 million apartment complex. You can list three potential replacements, whether their combined value is above or below $1 million. However, we do recommend finding at least one property that has a value close to that of the relinquished one. This is due to the equal or greater value rule, which we will discuss later.
The 200% rule allows an investor to identify an unlimited number of properties as long as the total value doesn’t exceed 200% of the relinquished property’s value. In our example above, you can list down as many like-kind properties as you like until you reach $2 million, which is 200% of $1 million.
This option allows for even more flexibility for investors. If the proceeds are too high for just one property, then the 200% rule allows you to exchange multiple like-kind assets so long as the aggregate value stays within the limit. Past that, and you’ll need to follow the 95% rule.
The 95% rule applies once you identify properties with a total aggregate value beyond 200% of the relinquished asset. If your apartment complex is $1 million, then selecting properties with a total value that’s past $2 million will subject you to this rule. While this stipulation allows you to identify as many properties as you want, the IRS will require you to acquire at least 95% of these properties. This means that you’ll need a higher capital to purchase the identified properties. As such, the 95% rule is seldom used in practice.
The equal or greater value rule is another critical requirement for the like-kind exchange. Under this stipulation, you must reinvest all of the proceeds from the property sale to purchase a real estate asset that has a similar fair market value (FMV) or greater. If you sold an apartment complex costing $1 million, then the property you should exchange it with should be $1 million or more.
The FMV only includes the net sale price after other valid expenses, such as closing costs and debts tied to the relinquished property.
Any mortgage or loan on the relinquished property must be matched or exceeded on the replacement property. Otherwise, you incur what is called mortgage boot. Let’s say that your relinquished property has a value of $1 million and a mortgage debt of $250,000. The acquired property is also $1 million, but its mortgage debt is only $200,000. In this case, you’re forgiven $50,000 in debt after the exchange. This boot is taxable.
Does the IRS allow you to acquire a property that has a lower value than the relinquished one? Yes, the agency does. However, you will incur a cash boot in this scenario, which is taxable. As such, this type of exchange is considered a partially deferred exchange because some tax liability still occurs.
If your original property had a $400,000 value and you exchanged it for an asset costing $360,000, then you’re left with a $40,000 cash boot. Based on the current tax rates, you could pay as much as $8,000 in capital gains taxes from this boot.
Thanks to the possibility of boot, most investors choose properties that are slightly above the value of their relinquished asset. Things do get more complicated when you’re exchanging multiple properties, such as if you follow the 200% rule. Proper planning and close coordination with your qualified intermediary becomes even more crucial to lower the chances of incurring boot.
1031 exchanges have distinct protocols for depreciation recapture and deferral. Depreciation refers to the deducted value of the property from its initial basis to compensate for wear and tear and other factors that reduce its value. However, there is a scenario where the IRS can recapture the claimed depreciation. More specifically, if you sold the property for a value higher than the cost-adjusted basis, then the IRS will recapture the excess. This amount is taxable as ordinary income, creating a significant tax liability.
Let’s say that you purchased a property 10 years ago for $10 million. Over the years, you were able to reduce its value to $7 million as it depreciated. However, you sold the property for $8 million. The leftover $1 million realized gain will be recaptured and taxed.
Thankfully, you can also defer depreciation recapture in a 1031 exchange. This happens when the depreciation basis of the relinquished property transfers to the replacement property. Thanks to this process, the acquired asset’s depreciation schedule is calculated using the original property’s adjusted basis instead of the purchase price.
Let’s say that a buyer purchased your relinquished property for $500,000. Its original purchase price was $600,000, but you depreciated it by $200,000. The final adjusted basis is $400,000, with the realized gain being $100,000.
If you purchased a like-kind property at $700,000, then we reduce the $100,000 realized gain since it will be deferred, paid only once you sell the property in a taxable transaction. Of the $600,000 leftover, the $400,00 carries over as the adjusted basis of the property while the other $200,000 is the additional value you had reinvested.
Engaging with a qualified intermediary is another major requirement in 1031 exchanges. This entity, also called the accommodator, oversees the entirety of the exchange. Their primary role is to ensure that you, the investor, don’t have direct access or control over the proceeds of the home sale. By creating this separation, the entire transaction remains compliant with the requirements of Section 1031 of the Revenue Code.
The IRS doesn’t require certifications on who can be qualified intermediaries, but the agency does restrict based on the relationship with the investor. For example, family members and professionals they’ve worked with cannot serve as accommodators. Examples of professionals include tax lawyers and accountants who’ve worked with you within the past two years.
The main reason for these additional rules and restrictions is to help prevent what’s known as a constructive receipt. To ensure that there’s no receipt of the proceeds — which is considered income — a third party must handle the funds. Otherwise, an investor having full control of the proceeds triggers a taxable event, disqualifying you from the tax-deferred status.
To maintain the arm’s length transaction, the qualified intermediary puts the funds into a separate account after the sale. It will continue holding the proceeds in escrow until you’re ready to purchase the replacement property. The accommodator then transfers the funds to the property seller since you’re not allowed to do so yourself.
Given how the accommodator is in charge of overseeing the entire exchange and holding the proceeds of your home sale, it’s essential to choose one that you can trust. Here are a few best practices to follow.
The IRS has also mandated certain title holding requirements to ensure compliance with the exchange process. One important rule is that the entity or taxpayer that relinquished a property must be the same one that acquires the new one. This rule ensures that the tax-deferred exchange is legitimate, avoiding tax liability by making sure the investor does not “cash out” of their investment.
Given this rule, you cannot transfer the title of a company from you to a different entity, such as a family trust, LLC, or partnership, and vice versa. If you do so, the IRS will recognize this as a sale instead of an exchange, disqualifying you from the tax-deferred benefits.
A reverse 1031 exchange happens when an investor acquires the replacement property before selling the relinquished one. The IRS has also another title holding requirement in this case, prohibiting an investor from owning both properties at the same time. As such, engaging with an exchange accommodation titleholder (EAT) becomes necessary. An EAT temporarily holds the title of the replacement property until you’re able to close the sale of the relinquished asset, preserving the validity of the exchange.
There are cases when one owner of a real estate in a partnership wants to reinvest their shares through a 1031 exchange. How does this work?
In general, partnership interests are not qualified for a like-kind exchange. This is because most types include assets that aren’t considered real property. As such, they violate the first rule we outlined above.
Thankfully, there is the so-called drop-and-swap approach. In this strategy, the partnership distributes the ownership of the real estate property to each individual partner. After the distribution, each owner holds their shares through a tenancy-in-common or TIC. The investor who wants to reinvest through a 1031 exchange can then sell their shares so long as:
These stipulations satisfy the like-kind requirement, the business or investment use requirement, and the title holder requirement.
The IRS has been known to closely scrutinize the drop-and-swap method, even though it’s perfectly legal. This is because there’s a high chance for partners who initially purchased a property to immediately use this method to avoid tax payments. This practice is a violation of the qualified use requirement. As such, demonstrating intent is crucial to avoid disqualification. For example, an investor can hold the TIC partnership for longer to prove their plan to use the property for investment purposes.
If a drop-and-swap is too risky, then another method is to exchange the property at an entity level. In other words, the partnership remains intact and sells the asset as a whole. However, this is much trickier, especially when it comes to convincing all members to exchange the asset.
Due to the qualified use requirement, it’s unsurprising that some investors may find it confusing whether or not vacation homes and mixed-used properties qualify for 1031 exchanges. Here are the rules that govern these types of assets.
The primary rule to follow for vacation homes is the Revenue Procedure 2008-16, which outlines safe harbor laws that allow investors to swap such properties. There are three main requirements.
Based on these requirements, the IRS primarily wants to enforce the qualified use requirement. You must be able to demonstrate that you used the vacation property for investment or business purposes. As such, lease agreements and rent payment records are crucial in case the agency scrutinizes your intent.
We’ve already mentioned that mixed-use properties are eligible for 1031 exchanges. To be more specific, the parts of the property used for business or investment purposes are the ones that are allowable for the like-kind swap. The area or unit used for residential use will not be eligible for tax deferral.
Let’s say that you own an apartment complex with 10 units. You occupy one unit, and the rest are rented out. If you exchange the property, only 90% (or whatever percentage is equal to the value of the 9 units) of the proceeds can qualify for tax deferral. Clear documentation of rental income and personal use is important to avoid disqualification.
Section 1031(f) outlines the “Special rules for exchanges between related persons” for one key reason: preventing taxpayers from using the process to avoid taxes by swapping properties with a related party. The related party could be any taxpayer that has close ties to the investors, such as immediate family members, business partners, and controlled corporations. These stipulations don’t outright ban any exchange between related parties. Rather, the rules put some restrictions to ensure that the process isn’t abused.
First, let’s discuss the one that applies to investors who want to buy from a related party. You will need to hold the property for at least two years after the exchange to prove your intent for investment use. If you dispose of the property, such as by relinquishing it again for another exchange, then the IRS may tax you.
The same 1031 exchange 2 year rule applies to property owners who want to sell a property to a related party. In this case, the IRS requires the seller to hold the property they bought during the exchange for two years to prove their intent.
Based on these rules, the IRS does allow related-party exchanges, but these transactions come with intense scrutiny. There are cases when the property is simply rented back to the original owner, which potentially undermines that swap’s legitimacy. As such, working with professionals who can guide you increases the chances of a successful transaction.
The rules outlined by Section 1031 are federal in nature and thus apply to all states. However, there are specific state rules that investors must take into account. The first one is the fact that not all states will follow the tax-deferral status. In other words, you will still need to pay the capital gains taxes levied by the respective state revenue department. This is the case in Pennsylvania. However, this may disappear as state tax laws change in the future.
Other states have the clawback provision — these are California, Oregon, Montana, and Massachusetts. For example, if you exchange a California property for one in a different state, the state has the right to levy state taxes once you sell the acquired property. This creates a double taxation scenario that could put a dent in your cash flow. So, it’s important to keep these specific rules in mind before committing to the exchange.
The final rule we want to discuss is the 1031 exchange 5 year rule, or the 2 out of 5 year rule. This provision typically applies to residential properties, specifically primary residences, of investors that want to enjoy the capital gains tax exclusion. To qualify a property as a primary residence, the homeowner must have lived in the home for at least two years of the past five years. If they can prove this, then the homeowner will be qualified for the $250,000 or $500,000 exclusion.
What does this have to do with 1031 exchanges? The rule applies to properties initially acquired during the 1031 exchange but were later converted to primary residences. To qualify for partial exclusion, the investor must meet the 2 out of 5 year requirement. In addition, the investor must have owned the property for five years or more. This rule balances the benefits of tax deferral with residential exclusions.
Many 1031 exchange requirements exist to prevent the abuse of this tax deferral strategy and ensure proper tax reporting. While there are various provisions for special cases like vacation homes, exchanging with related parties, and converted properties, these all go back to three main rules: qualified use, like-kind requirement, and the equal or greater value requirement.
Navigating these rules and stipulations can be daunting and confusing. To minimize the chances of errors and maintain your tax-deferred status, working with experts like us at Realized 1031 is the best practice. With our guidance and solutions, you can be more confident with the exchange and improve your chances of maximum tax deferral. Contact us today and schedule a consultation for further information.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.irs.gov/pub/irs-news/fs-08-18.pdf
https://www.investopedia.com/terms/r/real-property.asp
https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/
https://www.investopedia.com/terms/c/constructive-receipt.asp