In a 1031 exchange (aka like-kind exchange), an investor can defer capital gains from the sale of a productive real estate or business asset by “exchanging” it for “like-kind” property—provided certain IRS rules are met. What’s even better, you can swap until you drop since there are no limits to the number of times an investor can take advantage of the 1031 exchange.
The rules for exchanging are rooted in Section 1031 of the Internal Revenue Code. Here is a summary of the most important points of a qualifying 1031 exchange:
- “Like-kind” means both properties must be held for investment purposes (i.e., primary/vacation residences don’t count) and similar in nature, character, or class.
- A third-party intermediary is required to execute the exchange.
- You have 45 days to identify replacement property.
- You have 180 days to replace the relinquished exchange property.
- The price of the replacement property must be equal to or greater than the equity in the old property plus any outstanding debt.
How to Beat the Clock
Timing is crucial in qualifying for 1031 treatment.
In a 1031 exchange, the 45-day rule for identifying the replacement property and the 180-day rule to finalize the exchange are the most critical.
A 1031 exchange can be either simultaneous or deferred, with a deferred exchange being the most common by far—mainly for its flexibility. In a deferred exchange, an investor can sell an existing property but is not required to find and close on a replacement property until later (think 45-day and 180-day rules).
In addition, for a deferred exchange, the investor must use a qualified intermediary to act as an agent for holding net proceeds from the relinquished property before they are reinvested in the replacement property.
What Qualifies as Like-Kind?
A misunderstanding of what qualifies as like-kind property is the single biggest cause of stress for investors rushing to complete the exchange within the prescribed deadlines. Many investors believe that like-kind property must be of the same type, be located within the same geographic location, and be held through the same ownership structure in order to satisfy the 1031 exchange requirements. This is a common misconception.
In fact, not only does the property not have to be the exact same type in the exact same location, but you can also exchange for multiple properties or even swap into a co-ownership situation with other investors. Knowing this will expand your options and allow you to find a replacement property fast and close on that property within the required timeframes.
The most important thing to remember with a 1031 exchange is that the main criterion for establishing like-kind property is both properties in the exchange must be held for productive use in a trade or business.
Based on that definition, there is no requirement that the properties be of the same type or be in the same location. In fact, the IRS has been pretty liberal in determining what qualifies as like-kind property.
The following non-comprehensive list of real estate assets would qualify as like-kind property:
- Unimproved property
- Vacant land
- Net-lease property
- Commercial buildings
- Rental properties
- Farms or ranches
- Resort property
- Industrial property
- Retail property
- Office buildings
- Self-storage facilities
- Senior living centers
- Hotels or motels
As you can see, the possibilities are almost endless and there are no geographic requirements other than that the properties need to be located in the United States.
How to Locate a Replacement Property Fast
Look Beyond Your Current Market
Too often I see investors let the clock wind down to only a couple of weeks to spare to find a replacement property because they limited themselves to their local markets. They stayed in their comfort zone and expected to find a like-kind property in their own backyard.
As real estate investors, we often default to existing relationships in our own local markets, which sometimes is great for finding under-the-radar deals. But when dealing with a 1031 exchange, this may not be the best strategy—your local market may have limited inventory to choose from in that short of a timeframe.
To increase your options, reach out to brokers, contacts, people in your professional network, and so on in attractive markets outside your home state.
Based on what we know, it should come as no surprise that one trend I’m seeing more and more is investors from the West Coast exchanging into properties in Middle America. The Midwest has been attracting direct investors from the West Coast for years, but many of those needing to complete a 1031 exchange are now following the trend.
I additionally find exchangers looking to move from markets with headwinds to those with more attractive growth numbers, which all reinforce my stance that the most favorable exchanges might be found outside your backyard.
Although fractional interests in a REIT or partnership would not qualify as like-kind property for 1031 exchange purposes, exchanging property for property in a co-ownership situation is allowable under two circumstances:
- Property that is held through a Delaware Statutory Trust (DST)
- Property that is held through a Tenancy-in-Common (TIC)
Delaware Statutory Trust (DST)
The overwhelming advantage of exchanging into properties held in a DST is the opportunity to invest in a portfolio of properties instead of just one, thereby diversifying risk and insulating income. And just like investing in a private equity real estate fund or real estate syndication, you can invest headache-free by leveraging the expertise of others and letting someone else deal with the day-to-day management of this portfolio.
The major disadvantage of DSTs cited by many investors is illiquidity. Most DSTs have long investment windows of five or more years, so be prepared to relinquish control for the long run. Although considered a disadvantage by many, this same illiquidity is what shields DST and other private investments from broader market volatility.
Like DSTs, TICs also allows for greater diversification of your investment portfolio. Fractional or co-ownership interests in real estate through TICs allow you to acquire—together with other investors (no more than 35 co-owners)—a larger, potentially more stable, secure, and profitable real property asset than what you could have acquired and afforded on your own.
The one most cited drawback of TICs is personal liability. Because all co-owners must be named on the title and must be listed as a co-borrower on any mortgage on the acquired property, each co-owner can potentially be held responsible for the full outstanding amount of the mortgage, as well as for any potential property-related liabilities like personal injury and hazardous wastes.
The Bottom Line
Don’t forget the fundamentals of 1031 exchanges:
- You want your replacement property to make economic sense. No point in deferring capital gains if the property you exchange into performs poorly financially.
- Lose the stress with the 1031 exchange deadlines. Remember all your options, including the wide range of properties that would qualify as like-kind property, available to you. Explore the types of co-ownership that would allow for more diversification and insulation from downturns.
- Follow other investors into new markets. Take the opportunity to exchange into properties that perform better financially and in better-performing regions and cities like the Midwest.
Keep your options open to meet your deadlines and to potentially swap into a better financial situation.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.