How does a 1031 Exchange work?

22 Replies

Hi Bryan, There have been volumes written on this topic and case law that would fill a large VW van.  But in a nutshell here you go:

When you sell an investment property you’re required to pay tax on the gain. If the property appreciated in value during your ownership period or if depreciation deductions were taken for tax purposes, most states and the IRS views the gain as taxable.

However, a Section 1031 tax deferred exchange (also known as a Starker Exchange) named for the Internal Revenue Code Section it refers to, allows a deferral of capital gains tax. When you sell your business or investment real estate, replace it with a different business or investment real estate and use a 1031 exchange, you can defer payment of the capital gains tax normally required on these sales.

This gives you greater purchasing power by allowing you to use funds you would have paid in tax towards the new investment. Without using a 1031 exchange, you would be required to pay capital gains tax on the gain, thereby significantly reducing the amount you have to reinvest.

A 1031 Exchange is not a tax loophole. It is a 90+ year old section of the Internal Revenue Code, written by Congress, to allow anyone who meets the requirements to sell their property and defer paying taxes on the gain.

If the properties meet the following requirements, you may exchange any real estate for any other type of real estate:

1. All relinquished (old) and replacement (new) property must be vacant land, rental property or property used for trade, business or investment. 

2. You cannot have actual or constructive control of any of the proceeds received from the sale of the old property. By law, all money must be held by a Qualified Intermediary (also referred to as an Accommodator or Facilitator). You cannot have an associate or employee, your attorney, broker or CPA hold the proceeds, nor can you leave the proceeds in escrow until the second property is purchased. 

3. You have 45 days from the date of closing on the old property to identify a list of properties from which you will purchase the new property. 

4. From the date of closing, you have 180 days to close on one or more of the properties from your 45-day list. 

5. The titleholder on the old property must be the same titleholder on the new property.

6. You must reinvest all cash proceeds from the sale, and purchase a new property or properties of equal or greater value, in order to avoid taxation on the gains. 

Obviously, within these rules there a lot of specifics that can be crafted to your specific situation so it is important to make sure that there is coordination of your accounting professionals with the QI  handling your exchange.

But the most beautiful thing about 1031 exchanges is that you don't have to change your behavior of buy - sell - buy in the least to take full advantage of the powerful tax savings in a 1031 exchange.

That's your first look Welcome to the deep but very refreshing and rewarding end of the pool!

Concise Overview of 1031 Exchanges

What Is A 1031 Tax Deferred Exchange?

The 1031 Exchange allows you to sell appreciated investment real estate (or personal property) and defer the payment of your capital gain taxes by acquiring like-kind replacement property.  1031 Exchanges allow you to keep 100% of your money (equity) working for you instead of paying (losing) about one-third (1/3) of your funds (equity) to taxes. 

There are, of course, very specific requirements that you must follow so that your sale transaction will qualify for 1031 Tax Deferred Exchange treatment under Section 1031 of the Internal Revenue Code (tax code).

1031 Tax Deferred Exchange Requirement

The sale and the purchase transactions must be structured properly in order to qualify for tax-deferred treatment under a 1031 Exchange.  The Qualified Intermediary, often referred to  as the 1031 Exchange Accommodator or the 1031 Exchange Facilitator, will complete the necessary legal documents to ensure that you are in compliance will all laws, regulations and rulings.

It is critical that the Qualified Intermediary be  assigned into the Purchase and Sale Agreement or Contract and the Escrow Instructions, if any, prior to the close of your sale and purchase transactions.  Your transaction will not qualify for 1031 Exchange treatment if either transaction closes without your Qualified Intermediary being formally assigned into both transactions. 

Reinvesting or Replacing Your Investment Values

You must acquire one or more like-kind replacement properties that are equal to or greater in net purchase value than the net sales value of the relinquished property you sold.  You must reinvest all of your net cash proceeds from the sale of the relinquished property. And, you must replace the debt that was paid off on the sale of the relinquished property with an equal amount of debt on the like-kind replacement property (or new out-of-pocket cash). 

You can always add more cash into your purchase of your like-kind replacement properties, but you can not pull any cash out of the sale of your relinquished property without incurring depreciation recapture and/or capital gain income tax liabilities.

Qualified Use Requirement

Your relinquished properties and your like-kind replacement properties must have been held as rental or investment properties or used in your trade or business.  The critical issue is that you must have had the intent to hold the properties for investment purposes and not have held them for sale (i.e. inventory in your business).

Like Kind Property Requirement

There is a lot of misinformation regarding what constitutes like-kind replacement property.  It is not true that if you sell a condo you must acquire a condo, etc.  As long as your relinquished and replacement properties meet the qualified use requirement discussed above any kind of real estate held for investment is like kind to any other kind of real estate that is also held for investment. 

You can exchange out of or into any of the following asset types: single family, multi-family, commercial office, retail shopping, industrial, vacant land, oil and gas interests, mineral rights, riparian water rights, and tenant-in-common investments, etc. 

Multiple Assets and Fractional Interests

The 1031 Exchange allows you to easily reposition, diversify or consolidate your investment real estate portfolios.  You can sell one relinquished property and diversify your portfolio by acquiring multiple like-kind replacement properties, or you can sell multiple relinquished properties and consolidate your portfolio by acquiring fewer but larger like-kind replacement properties.  You can also sell or purchase fractional (partial) interests in property.

1031 Exchange Deadlines

There are very specific and mandatory 1031 Exchange deadlines that must be followed in a forward 1031 Exchange.  You have 45 calendar days from the close of the relinquished property transaction to identify potential like-kind replacement properties being considered for purchase and an additional 135 calendar days — for a total of 180 calendar days — to complete the 1031 Exchange by acquiring some or all of the identified like-kind replacement properties.

1031 Exchange Identification Requirements

You must  identify your potential like-kind replacement properties to your Qualified Intermediary within the 1031 Exchange time limits discussed above.  The identification must comply with one (1) of the like-kind replacement property identification rules outlined below:

Three (3) Property Identification Rule

The three (3) property identification rule is the most common rule and is used in most 1031 Exchange transactions.  This rule  allows you to identify up to but not more than three (3) potential like-kind replacement properties.  It is highly advisable that you  identify three (3) properties even if your intent is to only acquire one.  If you are looking to diversify your investment real estate portfolio and needs to identify more than three potential like-kind replacement properties one of the following two rules should be considered.

200% of Fair Market Value Identification Rule

The 200% of fair market value rule allows you to identify more than three (3) potential like-kind replacement properties as long as the total fair market value of all the potential like-kind replacement properties identified does not exceed 200% of the sales price of the relinquished property(ies).

95% Exception to Identification Rules

The 95% exception to the identification rules allows you to identify as many like-kind replacement properties as you wish provided you actually acquire and close on 95% of the fair market value actually identified.

I have a question about "6. You must reinvest all cash proceeds from the sale, and purchase a new property or properties of equal or greater value, in order to avoid taxation on the gains. "

In this simplified example:

Net sale price $225k
Original purchase price $175k
Remaining note $125k

Capital gain $50k ($225k-$175k)
Net cash at closing $100k ($225k - $125k)

If I do a 1031 for $100k but only end up using $50k as a down payment (on a $250k property), and I get the other $50k back...is that $50k that I got back taxable or not taxable since my original capital gain was only $50k?

First post...hope I asked it in the right place.  Thanks.

I have a similar question.
Let's say I purchased for 500k, standard mortgage. I sell for 1.5M. IRS allows up to 500k for married couples on sale of residence. Is there any way to structure the 1031 exchange such that I can keep the first 500k profit out of it and only apply the 2nd 500k to the exchange? I read something somewhere that a partial exchange was possible but it was not clear how that works and made no reference to the standard IRS 500k allowance

Hi Chris,

$225K is your net sale price, so that is the amount that you must reinvest, not just your equity of $100K.  You must acquire one or more replacement properties that have a total purchase cost of at least $225K, and you must reinvest all of your cash, if you want to defer all of your taxes.  If you trade down in value (e.g., buy replacement property for less than $225K) or you pull cash out, it will trigger taxable boot. In your case, if you have a gain of $50K, and you either trade down by $50K or more or you pull cash out of $50K or more, the 1031 Exchange will not provide any benefit and you will recognize all of you taxable gain.

Hi Richard,

1031 Exchange transactions only apply to property held for rental, investment or business use.  They do not apply to primary residences, second homes or vacation homes.  Primary residences fall under Section 121 of the tax code, which is the $500,000 tax free exclusion that you mentioned. 

However, in your example, if this was your primary residence and you had a $1.0 million gain, you could move out of the property, rent the property for about 24 months, and then sell.  In this case, you could still  say that you had owned and lived in the property for 24 months out of the last 60 months (2 out of the last 5 years) and would qualify for the 121 Exclusion, and because it was rented for the most recent 24 months and was rented at the time of sale, you would also qualify for a 1031 Exchange because you had rented it out for a period of time.   So, combining the two strategies is possible with proper planning.  In this case, you would get the $500,000 tax free (assuming that you are a married couple), and then you would have to reinvest the remaining $1.0 million.  Remember that you must reinvest the net sale price and not the profit or the equity.

Thanks for the clarification Bill.

Thanks, @Bill Exeter  

My home is 2 family.  I live in 1 unit and rent out the other.  Is it still only under the 121 exclusion and not qualified for 1031?

Hi @Richard Smith  

Excellent question! This is what we refer to as split use. There are a couple of ways it could go. Is it a two (2) unit with separate entrances, or is it a SFR with one common entrance and just rented space/rooms?

If it is a two (2) unit with separate entrances, then assuming both units are exactly the same size, you would qualify for both the 121 Exclusion and the 1031 Exchange.  50% of the gain would be allocated to the 121 Exclusion and 50% would be allocated to the 1031 Exchange.

What if I'm looking at buying 6 properties all co-located and sharing a parking lot? Is that disallowed?

@Bill Exeter  

It is a Brooklyn, NY brownstone.  Single entrance to the building into a common area entryway with separate entrances to my unit just inside and the rental unit up a stairway from there.  Units are roughly the same size.  Both 2 floors, approx. 1500 sq. ft. per unit.  Owner unit is basement (as defined by NYC Housing regulations) and 1st floor and is 2 bed 1 1/2 bath, rental is 2nd and 3rd floor, 3 bed, 3 bath.

It is a legal 2 family as shown on NYC ACRIS system, so I think it would qualify as what you have termed as split use, so from my original example, lets keep it simple and say:

1. 500k current mortgage AND original purchase price, just to keep these simple

2. sell for 1.5M = 1M profit (less closing costs, agent commission, and other fees, but again, keep it simple)

Could I take 500k cash out on the 121 exclusion, then put the other 500k + new 500k mortgage into the 1031?

Also, assuming the answer to the above to be yes, could the 500k cash + 500k new mortgage be split into multiple properties for the 1031?  For example:

100k + 100k mortgage for one single family rental house

2 x 200k + 200k mortgages for 2 duplexes

Generally the sale price, gain, basis, etc., would all be allocated between the two units on a square footage basis.  The sale price for the rental property would then be $750,000 and the sale price for the primary residence would be $750,000.  The gain allocated to the rental property unit would be $500,000 and the gain allocated to the primary residence unit would be $500,000. 

The actual amount of gain allocated to the primary residence would be tax free up to the $500,000 limit, if you are married. 

The 1031 Exchange would consist of a sale of $750,000, so you would need to acquire replacement property equal to or greater than $750,000 (less selling costs) and not the $1.0 million value.  You can certainly acquire multiple properties as long as the total values meet the 1031 Exchange requirements.

Thank you so much @Bill Exeter  

Would the current mortgage/debt carry over be split down the middle as well?  So rather than having to carry the full 500k current, I would only have to add 250k to the exchange?

Sorry to keep hammering you with these questions. At the moment this is hypothetical, but I'm meeting with a real estate agent on Saturday and these are roughly the actual numbers I may be looking at and if I can figure out how this works, and get my wife on board to take the huge plunge into immediate re-investment, I would really love to avoid having Uncle Sam take a huge chunk of money. Very scary prospect to even consider this, as I'm a total newb to real REI. I've managed to do very well just by buying my own homes and getting into the right area at the right time, but this is a whole other thing here with the possibility of a huge chunk of change at stake.

Originally posted by @Bill Exeter :

Buying multiple properties as part of a 1031 Exchange is not a problem.  The more properties involved the more complicated the 1031 Exchange can get.  Were you asking about buying six properties and living in one of them? 

 No, it would be 6 apartment buildings consisting of 46 units. I was concerned about the "identify up to 3 purchases" part and didn't know if I could only list 3 of the 6 buildings.

Originally posted by @John Batson

 No, it would be 6 apartment buildings consisting of 46 units. I was concerned about the "identify up to 3 purchases" part and didn't know if I could only list 3 of the 6 buildings.

You are referring to the three (3) property Identification Rule.  You can also look to the 200% of Fair Market Rule or the 95% Exception Rule when identifying your Replacement Property.  Here is more detailed information on the Identification Rules:

Identification Rules and Exceptions (1031 Exchange ID Rules)

You must comply with at least one (1) of the following identification rules or exceptions when completing the identification of your like-kind replacement properties:

Three (3) Property Identification Rule

The three (3) property identification rule limits  the total (aggregate) number of replacement properties that you can identify to three (3) potential replacement properties.  The vast majority of Investors today use this three (3) property identification rule.

You could acquire all three of the identified like-kind replacement properties as part of your 1031 Exchange, but most Investors only acquire one of the three identified properties.  The second and third identified properties are merely identified as back-up like-kind replacement properties in case you can not acquire the first property.

You will skip the three (3) property identification rule and use the 200% of Fair Market Value Rule if you are trying to diversify your investment portfolio and wish to identify more than three (3) like-kind replacement properties.

200% of Fair Market Value Identification Rule

You  can identify more than three (3) replacement properties as long as the total (aggregate) fair market value of all the identified replacement properties does not exceed 200% of the total (aggregate) net sale price of your relinquished property(ies) sold in your 1031 Exchange.  The limitation is only on the total (aggregate) identified value.  There is no limitation on the total number of like-kind replacement properties.

For example, if you sold relinquished property(ies) with a net sale amount of $2,000,000 you would be able to identify as many replacement properties as you want as long as the total (aggregate) value of the identified replacement properties does not exceed $4,000,000 (200% of $2,000,000).

95% Identification Exception

Its good to have choices, but be careful with this exception.  It is an exceptionally useful tool under the right circumstances, but can present some tricky problems. 

You may need  to identify significantly more like-kind replacement properties than the first two identification rules permit.  There is no limit as to the total (aggregate) number or value of identified like-kind replacement properties permitted under the 95% exception as long as you actually acquire and close on 95% of the value identified.

However, if you do  not acquire and close on at least 95% of the value of the identified like-kind replacement properties the entire 1031 Exchange transaction will be disallowed.

@Bill Exeter  

Thanks for the information! I might be in a quandary, the 6 buildings are over 200% of the sales price.

@John Batson  

Would the purchase be under one contract, one seller, one closing?  You had also indicated that the six (6) buildings share the same parking lot/structure, correct?  Would it be defensible to argue that the six buildings must be acquired together given that they are all "attached" to the same parking structure, or could any of the buildings be acquired and owned/operated separately regardless?

@John Batson  and @Bill Exeter  

Just some spit balling here, but if the 6 buildings are all now listed for sale separately, could you do your due diligence during the 45 day identification period, and IF you decide to close on the properties, get the seller to de-list, then re-list all 6 buildings as a single listing prior the the 45 day ID period running out, thus making them all part of a single listing/sale?

Bill, at what point do you have to decide upon which of the identification rules to operate the 1031 under?  Could John basically 'leave that blank' initially, get his due diligence on these buildings done w/in the identification time frame, and if he wishes to buy all of them, go with the 95% rule?  Obviously he would want to be near 100% sure of closing on them to go that route given the risk, but would it be possible to operate the 1031 under that scenario?

@Bill Exeter ,

How does 1031 apply to a group purchase situation? For example:

A group of 10 people raised $1M and bought an apartment complex for $4M. The property is titled to an LLC and each of the investors is a member of that LLC.

Later on they decided to sell that property for $5M and buy another one for $6M. 

Do they keep the same LLC to buy a new property?

Since they have to raise more money now, they decided to get 5 more investors for the new property. How does this affect 1031 transaction?

Thanks
Nick

@Richard Smith  It's actually much easier than that.  If all 6 are owned by the same selling entity it would be relatively simple matter as has been said before to issue one contract for all 6 on one settlement statement.  As you've heard above this is probably the best way to proceed.

However with regard to the other options they act more like choices that get eliminated rather than select the box options with regard to 3 prop/200%/95%.  As long as one of them applies when the dust settles on your exchange you are good.  If you can name 3 or fewer great.  If you have to name more than 3 but can keep the aggregate value of them to 200% or less of the sale then great.  But if you have to name more than 3 and their aggregate is more than 200% of what you sell and you can still close on 95% of the value of the list then you're good also.

If you have some flexibility in your closing dates the 95% rule can be used very easily.  Sell your relinquished property in such a manner that you are already under contract and close to closing on all of your replacement properties then close on everything you are going to close on during the 45 day identification period.  By default your 45 day list becomes every property you've already closed on. No risk that way.  

So if you have to use separate identifications for all 6 buildings then get flexibility in the closing of the sale and closing of the purchase so you can close on all of them during the 45 day period.  If one falls though then it is not included on your list and your exchange is complete with the ones you have already purchased.

Originally posted by @Richard Smith :

@John Batson  and @Bill Exeter 

Just some spit balling here, but if the 6 buildings are all now listed for sale separately, could you do your due diligence during the 45 day identification period, and IF you decide to close on the properties, get the seller to de-list, then re-list all 6 buildings as a single listing prior the the 45 day ID period running out, thus making them all part of a single listing/sale?

Bill, at what point do you have to decide upon which of the identification rules to operate the 1031 under?  Could John basically 'leave that blank' initially, get his due diligence on these buildings done w/in the identification time frame, and if he wishes to buy all of them, go with the 95% rule?  Obviously he would want to be near 100% sure of closing on them to go that route given the risk, but would it be possible to operate the 1031 under that scenario?

Hi Richard,

The way they are listed has no bearing on the Identification.  The issue is whether they are or could be acquired separately.  If the six buildings could in fact be acquire and owned/managed separately from each other they would be considered six separate properties for identification purposes - no exceptions.  If they must be acquired together because they must have the shared parking lot, we MIGHT be able to argue that they are one property.  The fact that they are listed together, under one contract together or closing together is not sufficient.  They truly must be required to be sold/purchased together in order to qualify as one property for ID purposes.

You must be able to demonstrate that you qualify under one of the Identification Rules at midnight of the 45th day.  You do not really have to "elect" or "choose" the method.  You just have to make sure that you qualify under one of them at the deadline.  So, yes, he could wait until 11:59 PM on the 45th day and then decide to use the 95% exception rule, but if he is unable to acquire at least 95% of the value then his entire 1031 Exchange would fail.

Originally posted by @Nick B. :

@Bill Exeter,

How does 1031 apply to a group purchase situation? For example:

A group of 10 people raised $1M and bought an apartment complex for $4M. The property is titled to an LLC and each of the investors is a member of that LLC.

Later on they decided to sell that property for $5M and buy another one for $6M. 

Do they keep the same LLC to buy a new property?

Since they have to raise more money now, they decided to get 5 more investors for the new property. How does this affect 1031 transaction?

Thanks
Nick

Yes, the individuals are not the owners/taxpayers. The LLC, which is treated as a partnership for tax purposes, is the actual owner/taxpayer. So, when the LLC sells the property the 1031 Exchange should be structured under the LLC and the LLC should acquire the replacement property. The partnership must be the entity used through out. There are other options available with advanced planning.

The LLC could raise additional funds by adding other members to the LLC. The partnership would still be the same partnership, but would merely have more partners.

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