1031 Exchange: What It Is and How to Use It

1031 Exchange: What It Is and How to Use It

If you own investment property and are thinking about selling it and buying another property, you should know about the 1031 tax-deferred exchange. This is a procedure that allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax. 

As usual, Expetitle has your back in explaining these concepts. We’ve highlighted key points of the 1031 exchange—rules, concepts, and definitions you should know if you’re thinking of getting started with a section 1031 transaction.

What is a 1031 Exchange?

In a field heavy with specialized terminology, it’s essential to start with the basics.

The term 1031 Exchange is defined under section 1031 of the IRS Code. To put it simply, this strategy allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property.

Under section 1031, any proceeds received from the sale of property remain taxable. For that reason, proceeds from the sale must be transferred to a qualified intermediary (rather than the seller of the property) and the qualified intermediary transfers them to the seller of the replacement property or properties. 

A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property.

When do you use it?

As an investor, there are a number of reasons why you may consider utilizing a 1031 exchange. Some of those reasons include:

  • You may be seeking a property that has better return prospects or may wish to diversify assets.
  • If you are the owner of investment real estate, you might be looking for a managed property rather than managing one yourself.
  • You might want to consolidate several properties into one, for purposes of estate planning, for example, or you might want to divide a single property into several assets.
  • Reset the depreciation clock. The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property.

It’s important to keep in mind, though, that a 1031 exchange may require a comparatively high minimum investment and holding time. This makes these transactions more ideal for individuals with higher net worth. And, due to their complexity, 1031 exchange transactions should be handled by professionals.

What Is Depreciation and Why Is It Important to a 1031 Exchange?

Depreciation is an essential concept for understanding the true benefits of a 1031 exchange.

Depreciation is the percentage of the cost of an investment property that is written off every year, recognizing the effects of wear and tear. When a property is sold, capital gains taxes are calculated based on the property’s net-adjusted basis, which reflects the property’s original purchase price, plus capital improvements minus depreciation.

If a property sells for more than its depreciated value, you may have to recapture the depreciation. That means the amount of depreciation will be included in your taxable income from the sale of the property.

Since the size of the depreciation recaptured increases with time, you may be motivated to engage in a 1031 exchange to avoid the large increase in taxable income that depreciation recapture would cause later on. Depreciation recapture will be a factor to account for when calculating the value of any 1031 exchange transaction—it is only a matter of degree.

“Like-Kind” is Broad-Based

Most exchanges must merely be of “like-kind”—an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But again, there are traps for the unwary.

1031 Timeframe Regulations 

There are two key timing rules you must observe in a delayed exchange.

The first relates to the designation of a replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can’t receive the cash, or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate replacement property in writing to the intermediary, specifying the property you want to acquire. The IRS says you can designate three properties so long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.

The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old. Note that the two time periods run concurrently. That means you start counting when the sale of your property closes. If you designate replacement property exactly 45 days later, you’ll have just 135 days left to close on the replacement property.

Tax Implication and Mortgages 

You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as “boot“—will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.

One of the main ways people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property. If you don’t receive cash back, but your liability goes down—that, too, will be treated as income to you, just like cash.

Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. You have $100,000 of gain that is also classified as “boot,” and it will be taxed.

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