Named after Section 1031 of the Internal Revenue Code, a 1031 exchange is an IRS provision that allows real estate investors to defer capital gains tax after the sale of an investment property, provided they reinvest the profit into another property of equal or higher value. Here's what they are, how they work, and how they benefit real estate investors.
On March 9th, 2023, the White House announced its $6.9 trillion budget plan for the 2024 fiscal year. In an effort to reduce the federal deficit by about $3 trillion, the proposal is targeting real estate tax strategies such as the Section 1031 like-kind exchange.
Interestingly, this isn’t the first time Section 1031 has been under fire. Last year, the White House recommended limiting the amount that could be sheltered by the provision to $500,000 for individual taxpayers and $1 million for joint filers, but Congress retained the measure when it passed the Inflation Reduction Act in August 2022.
Although the 2024 budget plan has brought the issue back into the spotlight, it merely remains an unofficial motion for now. To become law, the budget must navigate a divided House and a similarly gridlocked Senate.
Besides, there’s reason to believe that the provision has a net positive impact on the country’s economy. According to a 2021 study by Ernst and Young, like-kind exchanges generated over $48.6 billion in wages and benefits, supported nearly 976,000 jobs, and contributed a total of $97.4 billion to the nation’s GDP—far over the $19 billion in tax revenue its floated repeal is expected to generate.
In any case, this renewed attention on 1031 exchanges emphasizes the importance of understanding what like-kind exchanges are, how they work, and how they benefit real estate investors.
What is a 1031 Exchange?
Named after Section 1031 of the Internal Revenue Code, a 1031 exchange is an IRS provision that allows real estate investors to defer capital gains tax after the sale of an investment property, provided they reinvest the profit into another property of equal or higher value.
Colloquially known as a like-kind exchange or (less commonly as) a Starker exchange, this tax strategy applies to real property like buildings or land and allows taxpayers to defer capital gains tax by indefinitely reinvesting gains from one real estate investment into another. In the past, 1031 exchanges could also be applied to personal and intangible property, but the 2017 Tax Cuts and Jobs Act narrowed the provision’s scope.
Here’s an example to clear things up. Let’s say you purchased an eight-unit apartment complex in Kansas City for $1 million in 2018. Property values appreciated significantly in the last five years, and your property is now worth $1.3 million. So, you sell your apartment complex in 2023 and realize a $300,000 profit after accounting for commissions and closing costs.
If your long-term capital gains tax rate is 20%, you’d typically owe $60,000 in taxes. Wanting to defer your tax bill, you execute a 1031 exchange and reinvest your $1.3 million in proceeds from the sale of your apartment complex into a $2.6 million office building in suburban Las Vegas by taking on a mortgage. By using the proceeds from the sale of one property to purchase another, you successfully defer your $60,000 tax bill up until the year you sell your Las Vegas office building.
By 2040, you pay off your mortgage. In those 17 years, the property appreciated and is now worth $4 million. Should you sell your office building without conducting another 1031 exchange, you would face a $4 million – $1.3 million cost basis = $2.7 million capital gain * 20% tax rate = $540,000 tax bill, in addition to the $60,000 you deferred when you sold your Kansas City apartment complex in 2023.
However, if you perform another 1031 exchange, you can yet again defer capital gains taxes until you sell your subsequent property. Conduct enough 1031 exchanges, and you could potentially defer capital gains taxes indefinitely.
How to Conduct a 1031 Exchange
Because 1031 exchanges are such lucrative maneuvers for sophisticated real estate investors, the IRS imposes stringent rules and strict deadlines that you must adhere to in order to avoid triggering a taxable event. Though it’s recommended that taxpayers work with a professional to ensure the process goes smoothly, here are the basic steps for conducting a 1031 exchange.
Engage a Qualified Intermediary (QI)
Handling 1031 exchange funds before the exchange is complete could disqualify the entire transaction. For that reason, the IRS requires that you work with a qualified intermediary to coordinate the exchange.
A qualified intermediary sets up the legal agreements required to structure the exchange, holds sale proceeds of your current investment property (i.e. the relinquished property) in escrow, and transfers the funds for the new property’s purchase—all while following the IRS’ 1031 exchange rules to the letter.
While there are no federal regulations on who can be a QI, the IRS requires that the intermediary be someone other than the investor, a relative to the investor, or a disqualified person. A disqualified person is anyone who has acted professionally on behalf of the investor in any capacity in the past two years, like their accountant, attorney, or real estate agent.
Sell The Relinquished Property
Once you execute an exchange agreement with a qualified intermediary of your choice, you can list your current investment property for sale.
When your current property goes under contract, your qualified intermediary will be assigned the Purchase and Sale Agreement (PSA) drafted for your relinquished property and will work with the closing agent or title company to ensure that the sale proceeds are directed into a Federal Deposit Insurance Corporation (FDIC)-insured escrow account. To facilitate the 1031 exchange, include a clause in the purchase and sale agreement that indicates your intention to use the property as part of an exchange.
Identify Replacement Properties
After selling your investment property, you have a 45-day window to identify a replacement property. Once you find a replacement property, you must provide a signed and dated letter to the replacement property’s seller or your qualified intermediary. Your letter must be in writing and should include an unambiguous legal description of the property.
Remember that in a 1031 exchange, both the relinquished and replacement properties must be of “like-kind”. This means they should be of the same nature, character, and class. Essentially, you could exchange an apartment complex for an office building, vacant land, or another apartment complex, as long as the properties are used for business purposes and are located within the United States.
As mentioned earlier, ensure that the replacement property’s purchase price is equal to or greater than the sale proceeds of the relinquished property. Otherwise, you may generate “boot”, which is taxable. Boot is a portion of the sale proceeds that are not reinvested into the replacement property, and includes non-like-kind property like cash or a seller-financed mortgage.
During the exchange process, the IRS allows investors to identify up to three properties, regardless of their market value. Alternatively, you can identify more than three properties so long as the combined value of all replacement properties does not exceed 200% of the value of the relinquished property.
If you do not adhere to either the three-property rule or the 200% rule, you may identify an unlimited number of replacement properties if they acquire at least 95% of the total value of all identified properties. Because of this onerous requirement, this third approach is uncommon.
Close on the Replacement Property
The next step is to execute a PSA, perform due diligence, and close on the identified replacement property. You should include a cooperation clause in the purchase and sale agreement so that the replacement property’s seller is aware that the buyer intends to assign the contract to their QI upon completing the exchange.
Once assigned the contract, your qualified intermediary will use the proceeds from the sale of your relinquished property (along with mortgage financing, when required) to purchase the identified replacement property.
Notably, you have 180 calendar days from the day of the sale of your relinquished property to complete the purchase of your replacement property, even if the 180th day falls on a weekend or a holiday.
Report the Exchange
To inform the IRS about the 1031 exchange, report it on the tax return for the year in which your relinquished property was transferred using Form 8824. You will need to describe the properties exchanged, provide a timeline of the transactions, explain the parties involved, and document all monetary aspects of the exchange.
Types of 1031 Exchanges
There are four common types of 1031 exchanges.
Simultaneous Exchange
In a simultaneous exchange, the transactions involving the sale of the relinquished property and the purchase of the replacement property both close on the same day. This can be achieved via a two-party trade where the parties directly swap deeds or via a three-party exchange facilitated by a qualified intermediary or another third party.
Delayed Exchange
The delayed or forward 1031 exchange is the most prevalent among the four types of exchanges. In a delayed exchange, an investor sells their original property before acquiring the replacement property.
Funds from the sale of the relinquished property are held in escrow by a qualified intermediary while the property owner searches for a like-kind replacement property. As mentioned previously, the investor has 45 days to identify a replacement property (or properties) and must complete the transaction within 180 days.
Reverse Exchange
A reverse exchange is the opposite of a delayed exchange. The exchange begins with buying a replacement property through an exchange accommodation titleholder, or EAT, which assumes title of the property via a Qualified Exchange Accommodation Arrangement, or QEAA. Timelines are the reverse of a regular (i.e. delayed or forward) 1031 exchange.
In a reverse exchange, an investor has 45 days to declare the property they are willing to relinquish and 180 days to complete the sale of the property. In essence, investors completing a reverse 1031 exchange buy the replacement property first and sell the relinquished property later.
Improvement Exchange
Also known as a construction or built-to-suit exchange, this exchange allows real estate investors to use tax-deferred funds to improve or build upon a replacement property. Improvements must be completed within 180 days, while any remaining funds may be used to acquire additional like-kind property.
At TSG, we pride ourselves on being a reliable and knowledgeable investment partner.
Whether we’re cruising the fast-paced landscape of vc investments or dissecting nuanced tax strategies in real estate, we have the expertise to help partners like yourself navigate a broad range of asset classes and market conditions.
Get in touch with us today to see how 1031 exchanges can help you lower your tax burden and further your financial goals.
