A 1031 exchange is a financial tool that can assist investors in leveraging their investment gains to continue investing. Here’s how it works:
An investor sells a real estate asset that has appreciated. Rather than paying capital gains taxes on the appreciation, the investor performs a 1031 exchange to reinvest the proceeds into a “like-kind” property.
- The IRS allows almost any business property as a replacement. For example, residential rentals can replace office space, and an investor can swap retail assets for industrial property or farmland.
- The investor must replace the entire value of the property they sell (typically referred to as the relinquished asset) and any applicable debt.
- One significant provision of 1031 exchange regulations is that the investor may not have access to the proceeds from the sale during the exchange period. Most exchanges are delayed rather than simultaneous, requiring a Qualified Intermediary to manage the escrow.
- The exchange regulations also have tight time deadlines. For example, the potential replacement properties must be identified within 45 days following the initial sale, and the transaction must be completed within 180 days.
An investor can continue to conduct 1031 exchanges consecutively (holding the property for at least a year each time) and sequentially defer the capital gains taxes, which accrue with each iteration. If the investor maintains the practice indefinitely, they can distribute the assets to their heirs without paying capital gains taxes. After the grantor's death, the heirs would receive the property on a stepped-up basis, and no capital gains taxes would be due.
Is my bank a good place to go for 1031 guidance?
Successful execution of a 1031 exchange is complex. As mentioned, the timeline is tight. In addition, the requirements for the identification of replacement properties are stringent. Furthermore, the investor completing the exchange isn't allowed access to the funds during the process, which magnifies the challenge. Mortgage amounts or improvement plans further complicate some deals. For example, if the investor needs to improve the replacement property, the 180-day timeline is a limiting factor.
For these reasons, it’s essential to engage an expert to assist with a 1031 exchange transaction. Some banks offer the service, although most large ones do not have much experience. Wells Fargo is one example of a major bank that provides the service. One potential upside to using your bank is that you may already have a trusted adviser and potentially easy access to your accounts. However, while convenient, the bank with which you conduct other banking services might be disqualified from serving as your Qualified Intermediary, which is a vital part of the 1031 process.
Why would a bank be disqualified as a potential QI?
The IRS, which oversees 1031 exchanges (and ultimately determines whether to allow one), does not outline explicit qualifications for a QI. However, the code does detail what the QI may not be. The excluded parties list includes the investor, any family members, employers, employees, and agents. The "agent" exclusion specifically lists the following:
- Attorney
- Accountant
- Real estate broker
- Investment broker or banker
- Tax Advisor
Banks are not on the list, but having an account with the bank you use could cause the IRS to disallow your exchange, resulting in an unexpected and unwelcome capital gains levy. If you prefer to use a bank for the 1031 exchange, choosing one with which you have not conducted business in the most recent two-year period is best.
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.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
