1031 Exchange Basic Information

1031 Exchange Basics

A 1031 Exchange transaction is governed by IRS Code 1031. It allows an American taxpayer to exchange one investment property for another while deferring the tax consequence of the sale.

These are the IRS explanations for a 1031 Exchange:

Timelines: The investor, also known as the exchanger, must follow unbending rules for the transaction. Specifically, once a transaction is initiated by the sale of a relinquished property, the exchanger has 45 days to identify real estate that is the equivalent in value or greater. At the end of the 45-day period, the new or replacement property must be acquired within 135 days.

Like-Kind Property: Acquiring “Like Kind”property means the new property must be a qualifying form of real estate. For example, the exchanger could sell a condo and purchase land or buy a rental home and sell an apartment building. However, the tax overhaul that took effect on Jan. 1, 2018, has redefined like-kind to make it more restrictive.

For example, an acre of land that contains oil and gas reserves and certain reservoir, irrigation stock, or mutual ditch exchanges, remains eligible for a like-kind exchange.

Exchange Property Held for Investment: The relinquished property and the replacement property must be held for investment or business. As a result, a primary residence cannot be included in an exchange for another investment property, nor can an investment property be sold to purchase a primary home.

Equal or Greater Debt and Equity in a 1031 Exchange: If the exchanger sells a property for $1 million, in which $500,000 was equity and $500,000 was debt, then the exchanger needs to purchase $1 million or more worth of property. Further, the exchanger needs to use all the equity and replace all the debt to defer 100% of the capital gains taxes.

Under 1031(d), as stated on the IRS website, the basis of property acquired in a 1031 exchange is the same as the basis of the property exchanged, decreased by any money the taxpayer receives and increased by any gain the taxpayer recognizes.  You can always have more debt. The IRS says you just can’t go into an exchange with less debt.

There is the option for a partial exchange when the investor does not desire to use all of the sale proceeds, but this does require paying the applicable capital gains taxes on the difference.

Constructive Receipt and Qualified Intermediary for a 1031 Exchange: If an exchanger receives cash from the sale, it triggers immediate taxation called “constructive receipt” unless the exchanger has involved a Qualified Intermediary (QI) to facilitate, according to IRS safe harbor provision. 

The QI is preferably a fully vetted, reputable, insured, and bonded independent third party—not the exchanger’s CFP, attorney, agent, broker, or CPA.

Risks Involved With 1031 Exchanges

These 1031 Exchanges can be packaged in Delaware Statutory Trust (DST) and/or Tenants in Commonownership and, as with any real estate investment, there are potential downsides.

Unlike a Tenants in Common ownership, a DST’s decisions are handled by a trustee and no vote is needed.

Investors should thoroughly understand all risk factors and discuss them with a professional prior to investing in a Delaware Statutory Trust or Tenants in Common Exchange.

One common problem is the buyer who writes offers on multiple properties but only intends to purchase one. While this violates good-faith covenants inherent in contracts, it doesn’t stop it from happening. Ask the buyer’s agent if yours is the only offer being made.

For more information, consult with a real estate professional Thomas Applegate RE/MAX real Estate Specialists, a CPA, attorney, or CFP.

Post a Comment