How 1031 exchanges can benefit real estate investors

When you sell a business or investment property and make a profit, you may have to pay both income taxes and capital gains taxes on the profits at the time that the property is sold. Section 1031 of the United States Internal Revenue Code (IRC) provides an exception, allowing you to pay the taxes later if you reinvest the gains in a similar property and meet certain strict requirements. 

Selling one property and then using the money to buy another is not considered a like-kind exchange. For Section 1031 to kick in, the two properties need to be part of the same transaction. There are three ways this can happen.

1. Simple swap, in which two properties are exchanged simultaneously.

2. Deferred exchange, also known as delayed exchange, in which the investor sells their property first, and then acquires the replacement property. The sale of the first property and the acquisition of the second property must be mutually dependent parts of an integrated transaction. This typically requires an exchange facilitator since the investor cannot take control of cash before the completion of the exchange process.

3. Reverse exchange, in which the new property is acquired through an exchange accommodation titleholder. The titleholder can hold the new property for up to 180 days, during which time the taxpayer must sell the first property to complete the exchange. As with the deferred exchange, taking control of any proceeds before the exchange is complete will disqualify you from the 1031 exception.

To qualify for a 1031 exchange, both the relinquished property and the acquired property must meet certain conditions:

• They must be business or investment properties. Both properties must be predominantly used for business or investment, not personal use. So, your vacation home and primary residence don’t qualify, but rental properties do. 

• They cannot be purchased for resale. Although it’s likely that you’ll sell your investment property at some point, you can’t use the 1031 exception to “flip” properties.

• They must be “like-kind” properties, or similar in nature. If the relinquished property is real estate, any other type of real estate is considered “like kind,” so long as both properties are located in the United States. 

• They must be real property held. Types of property that do not qualify for a 1031 exchange include: inventory, stock, bonds, notes, securities, debt, certificates of trust, partnership interests, patents, intellectual property, machinery, artwork, and collectibles. Co-ops, however, do qualify for 1031 exchanges in New York State. 

Although exchanges can be deferred, they must meet certain time constraints: 

45 days to identify replacement properties 

You must identify and clearly describe a replacement property within 45 days of selling the original property. The identification needs to be in writing and delivered to the seller of the replacement property, not to your own attorney or real estate agent. 

180 days to complete the exchange 

In addition to finding replacement properties within 45 days, you have 180 days from the sale of the first property to complete the exchange. There’s one exception: If your tax return for the year that the original property was sold is due before the 180-day mark, you have to complete the exchange by the Internal Revenue Service tax return due date.

The replacement property or properties that the investor identifies need to meet certain requirements. There are three ways to do this:

1. Identify three properties of any market value. This is the most common method.

2. Identify an unlimited number of properties, as long as their combined market value does not exceed 200% of the market value of the original property.

3. Identify an unlimited number of properties, as long as the identified property or properties that the investor purchases have a market value equal to 95% or more of the market value of all identified properties.

In a deferred exchange or reverse exchange, you cannot take control of cash or other proceeds until the exchange is complete. During this time, the proceeds can be held by qualified intermediaries. A qualified intermediary cannot be yourself or your agent (anyone who has worked for you in the past two years). You can ask your attorney or real estate agent to recommend a trusted person to be your qualified intermediary. 

Like-kind exchanges can be complicated, so it’s a good idea to consult a professional about the individual tax implications. These two categories cover the basics.

Gains in the form of like-kind property are tax-deferred. 

This means that, if you exchange one property for a more valuable one, you don’t have to immediately pay taxes on the difference. Many investors try to defer taxes as long as possible. Some sell properties through 1031 exchanges until they’re ready to sell, or until their death. The property is then revalued, and the deferred tax is eliminated.

Gains that are not in the form of like-kind property can be taxed at the time of sale. 

If the replacement property is worth less than the relinquished property, any profits from the transaction, such as cash or non-like-kind property (called “boot”) is taxable. Most investors try to avoid boot by ensuring that the value of the replacement property is greater than or equal to that of the original property. If the relinquished property has a mortgage, the replacement property should have a mortgage of greater or equal value to the original property.

When used correctly, a 1031 exchange allows investors to take money that would otherwise be taxed and invest it back into a more valuable property. Instead of paying capital gains tax on the sale of an investment property, which could be 15–30%, a 1031 exchange allows investors to put that money directly into a new investment property. Here’s a simplified example

Mary owns an apartment building that she bought for $500,000. It’s now worth $1 million, and she’s thinking of selling. If Mary sells her building for cash, assuming a tax rate of 20%, she’ll have to pay $100,000 in taxes at the time of the sale, leaving Mary with $400,000 cash. 

Mary is also considering taking the profits from her apartment building and investing them into an office building, valued at $1 million, using a 1031 exchange. Trading one $1 million building for another means there’s no boot, and Mary does not have to pay taxes until she decides to sell.

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