Executing a 1031 exchange can be a useful approach for an investor to defer the payment of taxes on a capital gain when selling real estate investment property. However, a successful 1031 exchange requires diligent attention to the details of the IRS code and the rules and deadlines included. Some of the essential components include these:
- You must hold the real estate (the relinquished property) for investment purposes. Therefore, your residence won't typically qualify, although it's possible that if your residence is part of an investment asset, it might.
- The replacement property or properties must be "like-kind," which typically includes most types of investment property.
- A Qualified Intermediary must administer the exchange (also sometimes called an Exchange Accommodator). This individual or company oversees the transactions involved, holds the funds in an account separate from the taxpayers, and provides detailed accounting.
- Deadlines are crucial: replacement properties with a value at least equal to that of the relinquished property must be identified within 45 days of the initial sale, and deals must be finalized within 180 days (inclusive of the first 45-day deadline).
Before and After the 1031, Investor Actions Matter
The IRS has provided guidance for investors to clarify safe harbor eligibility for qualifying investments. Investors must have held the relinquished investment property for two years before the sale. This requirement applies to commercial properties or residential property used for investment. For residential assets, it is also essential to demonstrate that the property is used for investment by showing the time it is rented to others compared to use by the owner or family members.
Can I Transfer the Replacement Property to Someone Else After the Exchange?
After completing a 1031 exchange, an investor is typically expected to retain the replacement property. If the investor sells the property without completing another qualified exchange, the accumulated gains would be subject to capital gains. Since the tax liability is on an individual basis, any change in ownership could potentially trigger the realization of the gain.
One of the potential advantages of sequential 1031 exchanges for taxpayers is the opportunity to pass along assets to heirs at the "stepped-up value" of the property. For example, suppose that the investor executes a 1031 exchange several times, and over time the value of the assets increases from $100,000 to $5 million. That appreciation is significant, and if the investor were to sell the property, they would be responsible for paying capital gains taxes on the gain of $4.5 million. However, if the investor holds the property until death and bequeaths it to an heir, that heir inherits the asset at the stepped-up value of $5 million and can sell it without needing to pay any capital gains tax.
Also, Consider a 721 Exchange.
A 721 exchange is similar to a 1031 exchange but can allow the investor to shift from direct ownership to fractional participation in an UPREIT (Umbrella Partnership Real Estate Investment Trust) by using the proceeds from the sale of a property to buy units in an operating partnership that become shares of a REIT (Real Estate Investment Trust). This exchange also allows for the deferral of capital gains taxes and may facilitate estate planning since the shares could be easier to divide between multiple heirs.
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. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. There is no guarantee you will receive any income. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.