A 1031 Exchange, also known as a “Like-Kind Exchange,” is a tax deferral strategy used by experienced real estate investors to defer tax liability on the profitable sale of an investment property. The “1031” in the name refers to the section of the Internal Revenue Service (IRS) tax code that permits them, which states “…no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind…”
In other words, the capital gains taxes on a profitable sale are deferred as long as the proceeds from the “Relinquished Property” (the original property being sold) are reinvested into a “Replacement Property” (the new property being purchased) that is considered to be “like kind.”
In theory, an investor can defer taxes indefinitely by completing a series of successive 1031 Exchanges. This type of tax deferral can provide a powerful incentive for continued real estate investment, but they must be done correctly and within the bounds of the internal revenue code as written.
1031 Exchange Rules
To qualify for the tax benefits associated with a 1031 Exchange, the investor must follow the rules that are summarized below:
Like Kind Test: The Replacement Property must be “of the same nature or character” as the Relinquished Property. In addition, it must be located in the United States and held for “productive use in a trade or business or for investment.”
Time: From the sale date of the Relinquished Property, the Replacement Property must be identified within 45 calendar days and the purchase of it must be completed within 180 calendar days.
Value: The market value and equity of the replacement property must be the same as, or greater than, the value of the relinquished property. For example, a property with a value of $5M and a mortgage of $3M must be exchanged into a property that is worth at least $5M with $3M worth of debt.
No “Boot”: The term “boot” refers to any non-like kind property received in a 1031 Exchange. It could take the form of cash, installment notes, debt relief, or personal property and it is valued at “fair market value.” If boot is received, it doesn’t disqualify the exchange, but it could make it taxable.
Held For Sale: The replacement property cannot be “held for sale.” In other words, it can’t be purchased for the tax deferral benefits and then immediately sold. 1031 Exchange rules do not define a specific period of time that the replacement property must be held for, but it is generally agreed that a minimum of 12-24 months is a best practice.
Same Taxpayer: The taxpayer associated with the relinquished property must be the same as the one associated with the replacement property. In addition, both properties need to be similarly titled.
Property Type: A 1031 Exchange can be completed for any of the common commercial real estate property types including: apartment buildings/multifamily, retail, industrial, or office. Under certain circumstances, an individual may complete an exchange using their primary residence or rental property, but these are complicated and exceptions to the rule. Business property cannot be exchanged.
While the program rules are broad, the specific circumstances of an individual deal will dictate what type of 1031 Exchange an investor chooses to pursue.
Types of 1031 Exchanges
To meet the needs of different investors, there are four common types of 1031 Exchanges.
Delayed Exchange
A Delayed Exchange is the most popular type of 1031 Exchange and it happens when the exchanger sells their property (the “Relinquished Property”) first and uses the sale proceeds to purchase a new property (the “Replacement Property”) second.
To facilitate the sale of the Relinquished Property, it is common for an investor to use a third party, known as a Qualified Intermediary, who will hold the sales proceeds in escrow while a Replacement Property is identified. Under 1031 Exchange Rules, the Replacement Property must be identified within 45 days and the purchase must be completed within 180 days. This extended timeframe is what makes the Delayed Exchange the most popular variety, but it shouldn’t be taken for granted. There can be significant competition for the most desirable properties so it can be more difficult than it seems to find a replacement property.
Reverse Exchange
A Reverse Exchange is the opposite of a Delayed Exchange. In it, the Replacement Property is purchased before the Relinquished Property is sold. The same timing rules apply, but also in reverse. The Relinquished Property must be identified within 45 calendar days and sold with 180 calendar days. If an investor owns multiple properties, they will have to decide which one they are going to relinquish in the exchange.
A Reverse Exchange can represent an elevated level of risk for the investor because funds for the Replacement Property must be advanced before the Relinquished Property is sold and there is no guarantee that it will sell, much less within the required time period. For this reason, it is not a common type of exchange and is only used under the right circumstances.
Simultaneous Exchange
A Simultaneous Exchange is exactly what it sounds like. In it, the sale of the Relinquished Property and the purchase of the Replacement Property happen on the same day.
Tactically, there are three ways that a Simultaneous Exchange can take place:
Two Party Trade: In a two party trade, owners of the Relinquished Property and Replacement Property literally trade or “swap” deeds.
Three Party Exchange: In a three-party exchange, there is an “accommodating party” that acts as an intermediary to facilitate the transaction.
Qualified Intermediary: A Qualified Intermediary is an expert in 1031 Exchange transactions and works with the buyer and seller to manage the logistics. Their most important role is to handle the exchange of funds between the two parties to ensure the transaction remains in compliance with exchange rules.
Construction / Improvement Exchange
A Construction Exchange is used when there is some amount of repair or replacement that needs to be completed on the Replacement Property. In it, the investor sells the Relinquished Property, identifies a Replacement Property, and places it into the hands of a Qualified Intermediary (QI). While in the QI’s hands, the investor can use the sales proceeds of the Relinquished Property for renovations on the Replacement Property. Upon completion, they will take possession of the Replacement Property under three conditions:
It must be “substantially the same” as it was before the renovations;
Construction must be completed within 180 days of the Relinquished Property’s sale date.
The Replacement Property’s value must be equal to or greater than the Relinquished Property.
Again, the decision about which type of exchange to use will depend on the unique needs and requirements of the investor and the transaction. In many cases, a Delayed Exchange will suffice, but one of the other options can be used if the circumstances dictate.
A Note About Qualified Intermediaries
In many cases, a Qualified Intermediary may be used to facilitate a 1031 Exchange, regardless of type. Under 26 CFR 1.1031(k)-1(g)(4), a Qualified Intermediary is defined as a person who:
Is not the taxpayer or a disqualified person; and
Enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.
In many cases, the Qualified Intermediary is a company who specializes in this line of work. But, it could also be an attorney, accountant, banker, or broker who is familiar with 1031 Exchange Rules. The important point to note here is that whomever acts as a Qualified Intermediary is taking possession of sales proceeds and holding them in escrow until the purchase of the Relinquished Property closes. As such, it is critical to find one that has a strong reputation and the financial strength to remain in business as a going concern. Although rare, Qualified Intermediaries have gone out of business in the past, leaving many 1031 Exchangers exposed to a potential loss.
*Article from First National Realty Partners, Understanding the Four Types of 1031 Exchanges
