Using a 1031 exchange to move from one investment property to another while deferring the tax liability on any capital gain is a useful tool for real estate investors who want to reinvest the proceeds into like-kind assets. The name “1031 exchange” comes from Section 1031, Title 26 of the Internal Revenue Code, which contains the appropriate language that allows taxpayers to exchange real estate assets held for investment.
Suppose a taxpayer sells a property and reinvests the proceeds (following the 1031 exchange rules) into like-kind property. In that case, the investor can defer paying taxes on the capital gain and potentially achieve other goals, including risk mitigation, portfolio diversification, and others.
There are four ways to complete the 1031 exchange:
The most common usage of 1031 is the delayed exchange. The investor sells the original property (referred to as the relinquished property) and directs the proceeds to the Qualified Intermediary. This transfer is essential for the successful completion of the exchange. If the property owner takes possession of the money, the deal won't work. The QI holds the funds in escrow while the new (replacement) property is identified and then completes the transaction.
The 1031 rules require that identifying potential replacement properties occurs within 45 days of the sale of the relinquished property and that the replacement purchase be completed within 180 days (including the identification period.) Because this is an aggressive timeline, investors may want to consider initiating the search for replacement properties in advance of the relinquished asset's close.
It is important to note that the identification process is formal, and the taxpayer has three options from which to choose:
- Option 1 allows the taxpayer to identify up to three properties as potential replacements, with no restrictions on price. If the sale price of the relinquished property is greater than the purchase price of the replacement property or properties, the difference will be a capital gain.
- Option 2 allows for the consideration of an unlimited number of replacement properties, subject to a limit of 200% of the price of the property sold.
- Option 3 allows the taxpayer to specify an unlimited number of properties but requires that they acquire some number that adds up to at least 95% of their total market price.
If an investor happens to identify a desirable property before deciding to sell a property, they may initiate a reverse exchange. Assuming that the individual knows that he or she will want to do this, they must not purchase the new property directly since they cannot own both the replacement property and the relinquished property at the same time. In this situation, the investor will have the Qualified Intermediary (who can be referred to in this case as an Exchange Accommodation Titleholder) temporarily hold title to the new property while finding a buyer for the property designated for sale. The exchange is subject to the same time limits as a delayed exchange. If the targeted property to relinquish is not sold within the established timeframe, the exchange fails.
As the name states, a simultaneous exchange is a same-day buy and sell. It could be an actual trade of properties between two people, although that direct swap is unusual. The other possibility is when the investor sells the relinquished property and buys the replacement property on the same day. This transaction still requires either a Qualified Intermediary or another third-party to keep the taxpayer from actually touching the exchange of funds.
It's also important to remember that the replacement property must be valued the same or higher than the relinquished property, or the taxpayer will have a tax event.
Like the simultaneous exchange, the construction and improvement exchange is less common than a delayed or reverse exchange. It is used when the investor needs to improve the new property before taking possession. The individual sells the relinquished property, identifies the replacement, and while the QI holds it, the required improvements are completed. The QI can pay for those improvements using proceeds from the sale of the relinquished property, and the investor can take possession when the work is complete. Three conditions must be met for a successful exchange:
- The replacement property must remain substantially the same as it was before the construction.
- The work must be done within the 180 days following the sale of the relinquished property.
- The replacement property must be of equal or greater value than the relinquished asset.
The taxpayer's circumstances will determine the selection of the exchange type.