1031 Exchange

Understanding The Basics

If you own an investment Property and you’re considering selling it to purchase another property, then you should know about the 1031 tax-deferred exchange. So, what is it?

Well, the 1031 exchange is a procedure designed to allow a property owner to sell and buy a similar property while deferring the capital gains tax. In this post, you will find a summary of all the key points of the 1031 exchange concept, rules, and definitions that you need to know if you’re thinking of getting started with a 1031 section transaction.

1031 Exchange – What Is It?

A 1031 exchange gets its name from the Section 1031 of the U.S. Internal Revenue Code, which lets you avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within a given time limit in a property (or properties) of an equal, similar, or greater value.

The Role of Qualified Intermediaries

According to Section 1031, any proceeds you get from selling a property remains taxable. For this reason, the proceeds received upon selling should be transferred to a qualified intermediary, instead of the seller of the property, and the intermediary then transfers these proceeds to the seller of the Replacement Property or properties.

A qualified intermediary is basically an entity that agrees to facilitate the 1031 exchange by holding the transaction’s funds until they can be transferred to the seller of the replacement property. This qualified intermediary should not have any other formal relationship with the parties involved in exchanging the property.

When You Need a 1031 Exchange

As an investor, there are a couple of reasons why you may want to utilize a 1031 exchange. Some of these reasons include:

• If you wish to purchase a property that has better return prospects or you’re seeking to diversify your assets.

• If you’re looking to consolidate a number of properties into one for example, for the purposes of estate planning, or you wish to divide a single property into several assets.

• When as the owner of an investment property, you wish to acquire a managed property instead of managing one yourself.

• If you wish to reset the depreciation clock.

A key advantage of taking the 1031 exchange route instead of just selling one property and purchasing another is the opportunity for tax deferral. The procedure lets you defer capital gains tax, thereby freeing up more capital for investment in the replacement property.

Keep in mind that a 1031 exchange might require a relatively long holding time and high minimum investment. This makes the transaction generally ideal for people with higher net worth. Plus, due to the complexity of the transactions, 1031 exchanges should only be handled by professionals.

Depreciation and Its Relevance to a 1031 Exchange

Depreciation is quite an important concept for understanding the true benefits of a 1031 exchange. By definition, depreciation is the percentage of the cost of an investment real estate that’s written off every year, ideally recognizing the effects of wear and tear. Once a property is sold, the capital gains tax will be calculated depending on its net-adjusted value, which accounts for the property’s initial purchase price plus any capital improvements, minus depreciation.

In case a property sells for more than its depreciated value, you might need to recapture the depreciation. This means that the depreciation amount will be included in your taxable income from the sale of the property.

Since the depreciation amount recaptured will increase over time, engaging in a 1031 makes sense to avoid the significant increase in taxable income that a depreciation recapture would cause in the long run. Depreciation recapture is a key factor when calculating the value of any 1031 exchange transaction.

Timing and Rules of Choosing a Replacement Property

Similar or like-kind property is defined based on its characteristics and nature, not in terms of grade or quality. As such, there’s a broad range of exchangeable real estate properties. For example, you can exchange a vacant land for a commercial building, or exchange an industrial property for a residential one. However, you can’t exchange real estate for artwork, since this doesn’t meet the definition of “like-kind”. The property needs to be held for investment purposes, though, not for personal use or resale, which usually implicates minimum 2-year ownership.

To enjoy the full benefits of a 1031 exchange, the replacement property has to be of greater or equal value. You also need to identify a replacement property for the assets sold within 45 days and then complete the exchange within 180 days. In general, there are three rules that govern identification. In other words, you need to meet one of the following criteria:

• The 3-property rule lets you select three different properties as possible purchases, no matter their current market value.

• The 95% rule lets you choose as many properties as you’d like provided you acquire those worth 95% of their total or more.

• The 200% rule lets you choose an unlimited number of replacement properties provided that their cumulative value doesn’t go beyond 200% of the value of the property sold.

Types of Like-kind Exchanges

There are many different possibilities for making 1031 exchanges that vary in their timing and other aspects. Each of these has a set of its own procedures and requirements that have to be followed:

Delayed exchanges: these are carried out within 180 days, and the exchanges themselves have to be carried out one at a time.

Built to suit exchanges: these allow the replacement property to be newly constructed or renovated. However, they are subject to the 180-day time rule, which means that all the construction and improvement must be finished by the time the transaction is completed. Any improvements performed afterwards are considered personal property and don’t qualify as part of the exchange.

Reverse exchange: this occurs when you acquire the replacement property before you sell the property to be exchanged. In such a case, the property must be transferred to an exchange accommodation titleholder (or a qualified intermediary) and requires that a qualified exchange accommodation agreement is signed. The property for exchange must also be identified within 45 days of the property transfer, and the transaction is to be completed within 180 days.

Avoid Getting the Boot While Replacing your Property

Like-kind properties in an exchange must be of similar or greater value as well. The difference in value between a property and the one in exchange is referred to as a boot.

If the replacement property is of lesser value than the property sold, then the cash boot (difference) is taxable. If a non-like-kind or personal property is used to complete the transaction, it’s also “boot”, and still eligible for a 1031 exchange.

The presence of a mortgage is permissible no matter the size of the transaction. If the mortgage on the replacement property is less than that of the property being sold, the difference is also considered cash boot. This fact has to be accounted for when calculating the parameters of the exchange. Fees and expenses affect the value of the transaction and are therefore potential boot.

Some expenses can be paid using the exchange funds. They include:

• Qualified intermediary fees
• Broker’s commission
• Filing fees
• Title insurance premiums
• Related attorney’s fees
• Escrow fees
• Finder’s fees
• Related tax adviser fees

Expenses excluded from exchange funds include:

• Financing fees
• Maintenance and repair costs
• Insurance premiums
• Property taxes

Drop and Swap Exchanges

For LLCs, properties can only be exchanges as an entity, unless they carry out a drop and swap, in case there are some partners who want to make an exchange while others do not.

Interest in a partnership can’t be used when it comes to a 1031 exchange. This is because partners in an LLC don’t own property and just own interest in a property-owning entity – the taxpayer for the property.

1031 exchanges are ideally performed by a single taxpayer from one side of the transaction, which means special steps are needed for members of a partnership or LLC who aren’t in accord on the disposition of a property. It can get quite complex considering that every property owner’s situation is unique, though the basics remain universal.

When one partner is looking to make a 1031 exchange, and the rest are not, the partner can transfer their partnership interest to the LLC in exchange for a deed equivalent to their percentage of the property. This essentially makes the partner a tenant in common with the LLC, as well as a separate taxpayer. In this case, when the property is sold, the partner’s share of the proceeds will go to a qualified intermediary, while the partners receive theirs separately and directly.

If the majority of the partners agree to engage in a 1031 exchange, the dissenting partners can receive a given percentage of the property at the time of the transaction and pay their taxes on the proceeds while others go towards a qualified intermediary. This procedure is referred to as a “drop and swap” and is the most common procedure in such situations.

A 1031 exchange is meant for properties held for investment. A major diagnostic for holding properties for investment is how long the asset is held. It’s generally desirable to initiate the drop of the partner at least a year before the asset is swapped. Otherwise, the partners taking part in the exchange might be seen by the IRS as not meeting the necessary criteria. In case this is impossible, the exchange can be conducted first, and then the partners who want to exit can do so after a reasonable interval. This procedure is referred to as “swap and drop”.

Tenancy -in-Common Property Exchanges

Just as with drop and swap, tenancy-in-common is another variation of the 1031 exchanges. Tenancy in common is not a partnership or joint venture, but a relationship that lets you have a direct fractional ownership interest in a large property, alongside one to 34 more entities. This allows for a relatively small investor to take part in a transaction, and have multiple applications in a 1031 exchange.

Tenancy in common strictly grants the investor the ability to own a percentage of property alongside other investors, while holding the same rights as a single owner. The tenants don’t need permission from other tenants to sell or buy a share of the property. However, they do need to meet certain criteria (financially) to be eligible.

Tenancy in common can be used to consolidate or divide financial holdings, gain a share in a larger asset, or diversify holdings. It lets you specify the volume of investment in a single project, which is very important when it comes to 1031 exchanges where the value of a property has to be matched to that of another.

Estate Planning and the 1031 Exchange

One of the main benefits of taking part in a 1031 exchange is the fact that you can take the tax deferment through your lifetime. If your heirs inherit the property received through a 1031 exchange, its value will be stepped up to the current market, which ideally wipes out the entire tax deferment debt.

What this means is that if you die before you sell the property, you obtained through a 1031 exchange, your heirs will receive it at the stepped-up real market value, and all its deferred taxes will be erased. To make the most out of this opportunity, consider getting in touch with an estate planner for professional advice. Tenancy in common can also be used to structure assets in accordance with your personal wishes for distribution once you pass away.