Sometimes referred to as “like-kind exchanges”, 1031 Exchanges have been in existence for nearly 100 years and are used by thousands of real estate investors every year. The deferral of taxes resulting from the sale of investment property allows for investors to reposition investment real estate to help meet their objectives while preserving all of their equity so it continues to work for them.
- The investment property purchased (replacement property) must be of equal or greater value than the investment property sold (relinquished property).
- Investors must use all proceeds resulting from the sale of the relinquished property to purchase the replacement property.
- Both the relinquished property and replacement property must qualify as “like-kind” property.
There are many benefits of 1031 Exchanges. The primary benefit of a 1031 Exchange is the deferral of taxes resulting from the sale of investment property. 1031 Exchanges can only be used for the sale of investment real estate. No other types of investments have this very generous section of the tax code available to them.
- Deferral of taxes, including federal capital gains tax, state capital gains tax, net investment income tax, and depreciation recapture tax
- Maximize cash flow potential and investment dollars
- Eliminate inheritance and estate tax for beneficiaries
- Reduce risk through diversification
- Access to properties that do not require active management
- Access to different markets and property types
While 1031 Exchanges are flexible in the number of strategies that can be implemented, the rules put forward by the IRS are not flexible. Failure to adhere to IRS rules can result in either a failed Exchange, in which the entire tax liability is due or a Partial Exchange, in which a portion of the tax liability is due. The IRS’s motivation for allowing 1031 Exchanges is to facilitate continuous investment in real estate that is held for business or investment purposes.
Exchange rules focus on two primary elements. First, there is not an infinite timeline to perform a 1031 Exchange. Second, no “economic benefit” is received by an exchanger without having paid tax. The IRS defines “economic benefit” as either receiving cash compensations (i.e. sales proceeds) or a reduction in a liability (i.e. mortgage and debt payoff) without matching the liability with a corresponding liability on the replacement property or contributing additional equity to the replacement property.
Investors considering an exchange should become familiar with the details of 1031 Exchange rules. Here is a summary of the seven primary rules:
- The exchange must be set up before a sale occurs
- The exchange must be for like-kind property
- The exchange property must be of equal or greater value
- The property owner must pay capital gains and/or depreciation recapture tax on “boot”
- The taxpayer that sold and acquired the exchange property must be the same
- The property owner has 45 days following the sale to identify replacement properties
- The property owner has 180 days following the sale to complete the exchange.
There are many different types of 1031 Exchange properties for an investment property owner to consider. The IRS requires 1031 Exchange properties be “like-kind”, meaning investment property for investment property and includes all property types such as residential, industrial, commercial, etc. Given that all property types can be considered for a 1031 Exchange, the following property categories can be used to compare attributes and characteristics of 1031 Exchange properties:
* Defined by SEC as an individual with a net worth (excluding primary residence) of $1,000,000+ or annual income in excess of $200,000 for last two years for an individual or $300,000 for a couple filing jointly.
