A 1031 exchange is a tool that real estate investors sometimes employ intending to defer payment of capital gains taxes. By doing so, they can reinvest the entire proceeds from selling an asset. Fortunately, the IRS approved the use of this procedure, as long as the taxpayer carefully follows the rules.
What are the requirements for a successful 1031 exchange?
First, the assets included in the transaction must be “like-kind” investment properties. Before the Tax Cuts and Jobs Act (TCJA) took effect, investors could employ a 1031 exchange to relinquish and replace various investment assets, including machinery and collectibles.
The TCJA codified limits to the exchange, excluding assets other than business property. However, virtually any income-producing property is eligible. For example, you can sell a residential rental and reinvest in an office building or sell the office building and reinvest in retail properties. Alternatively, you can use the process to alter your geographic focus or sector concentration or achieve other changes to your commercial real estate portfolio, taking advantage of the investment potential of any value increases in your properties.
What are the restrictions to a 1031 exchange?
One crucial requirement is that the investor replaces the value and the debt level. That means that if you sell a property worth $400,000, on which you have a mortgage of $300,000, you must replace that property with one or more new assets with a combined value and encumbrance of those amounts. Failing to do so exposes the taxpayer to disqualification for the exchange and imposition of capital gains taxes.
Once you sell the property you decide to dispose of (referred to as the relinquished property), you have 45 days to identify potential replacements formally and 180 days (including those initial 45) to complete the transaction. It's a tight timeframe. There are additional requirements for the identification and acquisition of replacement properties, with three options for achieving success:
- Identify up to three potential replacements, with no rules around the individual or total value. Then, the investor must buy one or more of the three and replace both the value and debt level of the relinquished property.
- Identify and evaluate an unlimited number of properties, with a maximum combined value of 200% of the original asset. Again, the investor must ultimately purchase one or more properties to replace the value and debt.
- Identify as many properties as you wish but during the allowable period, purchase at least 95% of the combined market value (which is equal to or greater than the relinquished property’s cost).
Can I handle this on my own?
No. One of the rules governing 1031 exchanges is that the transaction must be managed by a Qualified Intermediary, a professional who is also sometimes called an Exchange Accommodator. This individual (or company, in some cases) is responsible for ensuring that the investor does not have access to the proceeds from the original sale. They establish a separate account to hold the funds. They also receive notification of identified replacement properties from the investor. The QI administers the replacement purchase and manages the taxpayer's documentation collection. In most cases, the QI receives a flat fee payment for their services. Choosing a QI who knows the rules is critical because an improperly handled transaction can result in the need to pay capital gains taxes and potentially depreciation recapture charges.
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.
