Information presented here is what we learned, not advice on what you should do. It is presented only for self-education. This is not expert advice. This is not legal advice. I am not a lawyer. I am not an accountant. I am a licensed real estate agent in California, but I am not your agent. Consult a professional that works for you.
Summary
In the following article, you will learn about 1031 exchanges and will cover the following topics and more.
- 1031 exchange is a tax-deferred exchange of one or more properties into one or more other properties.
- To qualify as a 1031 exchange, a sale and later purchase of property needs to uphold a number of rules.
- There is also a need to use a reputable qualified intermediary (QI) to serve as your escrow and contact point.
What is a 1031 exchange?
1031 exchange is a tax-deferred exchange of one or more properties into one or more other properties.
A curiosity, 1031 exchanges do not apply only to real estate, although I have personally only dealt with that aspect. You can, for example, 1031 exchange livestock. But, exchanging some livestock for livestock of different sex is not considered like kind [26 U.S.C. § 1031 (2018) (e)]. Since we won’t be dealing with livestock here, I mention this section as a curiosity, as the terms “kind” and “in-kind” that permeate the 26 U.S.C § 1031 are archaic expressions for livestock younglings. The more you know™.
In a 1031 exchange, one or more properties are sold, and one or more properties are then bought within a framework of constraints. Any capital gains that have been achieved by the sale are deferred. That is, they are not paid until at some later time a property is sold without taking part in an exchange. Or, you die, whichever comes first.
For us this means, we can replace a piece of real estate with another piece of real estate, and not pay capital gains tax at the time of sale. You still owe this tax, but you get to pay it once you get taxable income in hand.
The 1031 exchange gets its name from the Section 1031 of the Internal Revenue Code, which spells out all the rules of the exchange in dry but abundant detail.
The properties you sell are called relinquished properties. You can have one or more such properties in a 1031 exchange.
The properties you buy are called replacement properties. You can have one or more such properties in a 1031 exchange.
Exchange rules
To qualify as a 1031 exchange, a sale and later purchase of property needs to uphold a number of rules.
The properties must be investment properties. It has to be “property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” [26 U.S.C. § 1031 (2018) (a)]. Some property can never be used in a 1031 exchange [26 U.S.C. § 1031 (2018) (a)(2)]: stocks, bonds, notes, other securities or evidence of indebtedness, interests in partnerships, certificates of trust, other “choses in action” (rights to sue) (huh?)
They must also be “like kind”. For investment real estate properties, like kind is very liberally defined. In fact, I have not noticed any specific constraints at all, as long as you sell investment real estate to buy other investment real estate, and uphold other 1031 exchange rules. This means that pretty much any real estate can be turned into any other: a portfolio of rentals into a building, or a piece of land, and so on. If, however, you end up spending some of your 1031 exchange money for a property that does not qualify as like kind, you will owe capital gains taxes on that part of your money.
The replacement property (or properties – I will use singular to mean both singular and plural hereafter) must be of equal or greater value. If you are selling a $1M building as part of your exchange, your replacement must be $1M or more.
The replacement must take on an equal or greater amount of debt. So for example if you have a loan for which $100,000 remains to be repaid, you will need to take a replacement property with $100,000 or more in debt.
You must clearly identify replacement properties within a 45 day time window from the sale of the first relinquished property. We’ll see the identification procedure later.
You must complete the purchase of replacement properties within a 180 day time window from the sale of the first relinquished property.
The names on the title of the relinquished property must be the same as the names on the title of the replacement property. This holds for actual persons and companies alike. You could be put on the title in addition to someone else, i.e. you can buy a fractional interest in a replacement property. But, for example, you can not hold title in a relinquished property in your own name, but hold title in a replacement property in the name of your company. Nor the other way around.
There is practically no leeway with the above rules. Miss a deadline, and you blow the exchange. An exception is a presidential declaration of a disaster, but this is not something to count on realistically.
Facilitator
Through the duration of the 1031 exchange you must not handle any money from the sale of the relinquished property yourself. You must appoint a facilitator, or a dedicated qualified intermediary to handle the funds for you. You can not be a facilitator for yourself, nor can it be anyone who works for you in any capacity, nor has worked for you in a time window of 2 years.
Any money you receive in hand from the sale of the relinquished property is called boot, and is subject to capital gains tax. You should avoid boot in order to maximize the value saved by the 1031 exchange. Selection of a facilitator is important. This is a person, or a company, who will handle your money during the exchange. This means that you must be sure that they won’t run away with your money, or declare bankruptcy while your funds are in their possession. Remember, even if you blow your 1031 exchange deadlines due to someone else’s fault, you are still on the hook for the capital gains taxes. There is no way around it.
I think the best bet for a facilitator is to use a qualified intermediary (QI) company, such as IPX1031. 1031 exchanges is practically all they do. They are knowledgeable and work fast, for a nominal fee. The last time we used their service, we were charged a fixed fee of $950 for the first property, and $350 for each additional property involved. These fees are paid from the proceeds of sale of the relinquished property. You will get a contact point from the QI, who will ask you for the contact info of your transaction coordinator, and will work with them to ensure that your transactions go smoothly. If you inform your QI on time, there will be no delay to your transactions resulting from QI’s involvement. There are other QI companies but we had experience with this one. I am not paid to endorse IPX1031, they are simply so good that I want to share this value with you. Since the competence standard in this branch of real estate industry seems high, I would not be surprised that there are other QIs that are just as good. If you need someone to be your QI, visit their website and complete their intake form. Someone will be in contact within 24 hours and will help you move the process forward.
Identifying replacement property
As a prerequisite to completing the replacement leg of your 1031 exchange, you must identify replacement properties. The easiest way to identify properties is to fill out a form that your QI will give you with information that clearly identifies the properties you plan to buy. You then MUST sign and send this form to your QI before the 45 day identification deadline expires. The QI may send you reminders of this, but they are not responsible for driving the process: you must do that yourself.
Identification is subject to rules, you can not simply do whatever you want:
- Three property rule. You can identify up to 3 properties, no matter what the total market value is; or
- 200% rule. You can identify as many properties as you like, but their market value must not be greater than 200% of the value of your relinquished property; or
- 95% exception. You can identify as many properties as you like, no matter their total market value, BUT the value of the properties you buy must be at least 95% of the value of all the properties you identified.
So, as you see, you are not free to choose any properties that come across your desk. Do yourself a favor and remember them. As a memory aid, note that you are either constrained by the number of properties you can identify (rule 1), or the total market value (rule 2). An exception is, if you are very sure that you will buy all the properties you listed, you can put as many as you like without regard to the total market value. You then have some allowance for some of the transactions not to go through. The rule 3 seems to be designed to allow you to exchange into a portfolio of properties, and I don’t think it is otherwise a realistic strategy, except perhaps by accident.
When sending identification forms, make sure you uphold the three rules, and that you identify the properties clearly. Any mistake in identification will invalidate the 1031 exchange. Most of the time, in urban areas, property addresses are good enough. If in doubt, talk to your agent for guidance for proper identification.
You can send as many identification forms as you like until the identification deadline. However, sending new forms is additive (i.e. it adds to the properties you already identified), unless you explicitly cancel previous identification forms. So if your replacement properties change, be sure to communicate this properly to your QI.
What can a QI do for you
The primary role of the QI is to be an escrow for your money during the 1031 exchange transaction. They will receive your money from the sale, and hopefully keep it safe up until it is time to wire it to the purchase transaction.
The QI will subtly nudge you along the 1031 process here and there as a courtesy. But this is NOT their responsibility. You are on the hook to know and execute the exchange properly.
QI can also pay earnest money deposits from your escrow account for you. This may be significant for large transactions with a non-trivial amount of money involved. However, the procedure for doing this is exceedingly complicated: you will need to assign your purchase contract to the QI to enable them to send the money. And I guess, they need to assign the contract back to you once the process is complete. The details on this are not clear to me. Talk to your QI contact person to learn the details in case you are curious and want to use this possibility. My hunch is that it is not worth the trouble to increase the paper workload unless the EMD amounts are really large.
If you pay the EMD yourself, you can be eligible to be refunded the earnest money deposit if the escrow account for your transaction has money left after the closing. It is not possible to earmark the funds for this purpose ahead of time, so it seems unlikely that this would be feasible in realistic situations. But, that option exists. Be sure to notify your QI say a week in advance to ensure that this happens timely.
What if the 1031 exchange fails
This can happen. If your 1031 exchange fails for some reason, you will owe capital gains taxes. Taxes will be payable when the tax return is due for the year in which the exchange took place. Talk to your CPA to understand your tax obligations in that case. Preferably talk to them ahead of time, so that you understand your options fully before you start your exchange.
You may need to wait a long time to see your money. The QI is allowed to hold your money in escrow until the 180 days of your exchange period expires, regardless of when it becomes certain that the 1031 exchange process failed. This can have a weird effect of owing taxes but not having the money in hand to pay, depending on how unfortunate your timing happens to be.
What happens to the tax basis for the replacement property
Your tax basis is transferred to the replacement property from your relinquished property. You must track your tax basis carefully across exchanges.
This transfer of the tax basis puts a damper on how much you can depreciate the replacement property.
A refresher in case you forget: your property’s tax basis is purchase price minus depreciation plus capital improvements.
Reverse 1031 exchange
Although a 1031 exchange usually starts by selling the relinquished property and looking for replacement thereafter, nothing prevents you from reversing the order of transactions.
You can buy the replacement property first, and only then sell the relinquished property. In this case, you will have to find the money to purchase the property yourself, and you will get reimbursed at the end of the 1031 exchange. All rules and deadlines remain unchanged.
What if I don’t want to do a 1031 exchange?
The 1031 exchange rule in real estate motivates property owners to stay invested in real estate. This way, the government provides a tax incentive for housing providers to provide their property as housing for people or businesses. But, since properties deteriorate over time, staying invested in real estate to infinity and beyond at some point may become a burden to some property owners. They may want a way out. A problem in that case would be massive amounts of capital gains tax owed, which may not be something that you would be inclined to pay.
A few tax vehicles exist that may help you stay invested in real estate, but shed the responsibility of maintaining the properties ad infinitum.
The first one is a Delaware Statutory Trust (DST). This is, in short, a 1031 exchange aware syndication. You are allowed to roll the proceeds of your property sale into a DST. From there onwards, you can become a passive-only investor and continue collecting your gains from the operation of the DST. True mailbox money indeed.
Another situation in which a DST may be helpful is if your 1031 exchange is in danger of falling through, for example if you think you can not identify any suitable properties within the 45 day identification window. You can then quickly transfer your funds into some DST as a way to defer your capital gains taxes even without a replacement property in hand. There are companies that specialize in this use of DST, but I have not dealt with them and can not recommend any. A downside of DSTs are the fairly high upfront fees: the DST operators know that their clients are usually pressed on time, and may be willing to accept to part with a little bit of their money upfront, so long as that amount is less than what they might otherwise owe in capital gains.
A middle ground may be to join a syndication as a general partner – sponsor. If you are a sponsor anyways, then you are all set. If, however, you would be joining a syndication in which you do not have a special relationship with existing sponsors, you must strike a deal with them to be put on the title of the property to be bought. This is because you must be on the title of the replacement property in exactly the same capacity as you were in the relinquished property to uphold the 1031 exchange rules.
Conclusion
I hope that I explained the rules of 1031 exchanges in a bit more detail than you may find in other places on the Internet. You may find other texts which go into different levels of detail, but this is what I usually explain when asked.
While there are quite a few fine points in the above text, the main takeaways are:
- Tax deferral. 1031 exchange allows you to defer capital gains when exchanging real property for another.
- Rules. It is subject to numerous rules, which you must uphold to execute the exchange properly.
- You need help. Use a reputable qualified intermediary (QI) to serve as your escrow and contact point.
- Escape hatch. If your 1031 exchange is in danger of failing, there are options to avoid failure in the 11th hour.
Thank you for reading.
