What Is a 1031 Exchange?
Why Is a 1031 Exchange Important?
As an example of a first 1031 exchange, Ken purchased a condo five years ago for $200,000 with $20,000 down. He used it as a rental property for the past three years. Over the time of Ken’s ownership, the value of the condo has appreciated to $305,000. He’d like to better leverage his equity. If he sold the property and kept the approximately $100,000 profit, he could owe capital gains taxes of 15 to 20 percent. However, since it has been a rental property, Ken’s sale qualifies for a 1031 exchange. He can buy one or several investment properties, defer the tax, and invest the entire $100,000. Ken would only pay capital gains taxes on any portion of the $100,000 not used to purchase a new property or properties. A 1031 exchange can be a tax-efficient strategy to preserve capital and, over time, build a legacy investment portfolio.
What Types of Properties Qualify for a 1031 Exchange?
1031 Exchange Rules Explained
Rule 1: Like-Kind Property
The property sold and the property acquired must be “like-kind.” Most U.S. real estate investments will qualify. One property can be exchanged for varied replacement properties, and multiple properties can be reinvested into one larger property.
Rule 2: Greater or Equal Value
The total value of acquired properties must equal at least 95 percent of the sold property’s value. The sale of one property for $1,500,000 can be exchanged into three properties valued at $800,000, $300,000, and $600,000 because the total value of the replacement properties exceeds the price of the original sale. Understanding that real estate transactions come with significant fees, closing costs such as inspections and broker fees are counted toward the total value of the new property.
Rule 3: Investment or Business Property
A 1031 exchange is only applicable for investment or business property—not personal property or a primary residence. A former primary residence that is now a rental usually requires a minimum of two consecutive years as 100 percent rental property to qualify. One interesting case is the sale of a four-unit property in which one unit is owner-occupied. In this case, the sale can be treated as a three-quarters investment property and one-quarter primary residence.
Rule 4: 45-Day Identification Window
Once the first property closes escrow, the seller has 45 calendar days to identify up to three potential replacement properties. Experts recommend submitting offers on each replacement property and doing as much due diligence as possible before the 45-day countdown is over. An exception to the three property limit is known as the 200 percent rule. Here, the investor can identify any number of properties as long as the value of all combined is less than 200 percent of the first property’s sales price. In this case, if a property sold for $2 million, any number of replacement properties could be listed as long as their total value adds up to less than $4 million.
Rule 5: 180-Day Purchase Window
Including the 45 days to identify qualifying replacement properties, the investor has a total of 180 days to complete the purchase.
Rule 6: Same Taxpayer
The tax return and name appearing on the title of the sold property must be the same as the tax return and title holder of the new property. The 1031 exchange is not an opportunity to transfer property between owners or entities. The same seller must purchase the new property.
Rule 7: Use a Qualified Intermediary
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 are transferred to the seller of the replacement property. The qualified intermediary is a neutral third party and can have no other formal relationship with the parties exchanging property. If an investor were to take possession of the sales proceeds before closing on the replacement property, no 1031 exchange would be possible, and taxes would be owed on the sale.
Types of 1031 Exchanges
In a simultaneous exchange, the replacement property is identified and under contract before closing on the first property. The replacement property can close within a day of the first sale. In this case, the use of a qualified intermediary or 1031 exchange company is not necessary. The escrow company from the first sale can transfer proceeds directly into the escrow account for the new purchase. A simultaneous exchange also applies when two parties “swap” deeds.
The delayed exchange is by far the most common. It occurs when the investor relinquishes the original property before targeting replacement property. The delayed exchange is subject to the 45-day identification period and the 180-day deadline to close escrow.
In a reverse exchange, the investor purchases a property for cash and then identifies a property to sell to exchange into this newly acquired property. On paper, this type of exchange seems simple: buy first and sell later. What limits a reverse exchange is that it requires all cash for the purchase until the 1031 exchange proceeds can be applied. A failure to adhere to the 1031 exchange rules can result in a forfeit of the exchange. With a reverse exchange, investors have 45 days to identify “the relinquished property” to be sold, and a total of 180 days to close the sale.
Construction or Improvement Exchange
The construction exchange allows investors to improve the replacement property using the exchange equity. In this case, the entire exchange equity must be spent on completed improvements or as down payment by the end of 180 days.