What Is a 1031 Exchange?
In a 1031 exchange, an investor sells a property and reinvests the proceeds into another property of equal or greater value while deferring capital gains taxes. The exchange must meet certain requirements under Section 1031 of the (Internal Revenue Code) to qualify for tax deferral.
How Does A 1031 Exchange Work?
What Is a Qualified Intermediary? And how to choose the right one?
A 1031 exchange, also known as a like-kind exchange, involves swapping two investment properties. Classically, these transactions would occur between two people who each wanted the other’s property. It is extremely unlikely that you will find someone with a desirable property who also wants to acquire yours. Therefore, most people have to perform a delayed exchange, also known as a three-party or Starker exchange.
After selling their relinquished property, the seller must identify a like-kind replacement property within 45 days and purchase it within 180 days. However, the seller cannot hold onto the funds during that period. A qualified intermediary is required instead of the IRS (Internal Revenue Code).
Essentially, a 1031 exchange, or like-kind exchange, involves swapping two investment properties. These transactions typically occur between two people interested in each other’s property. You will unlikely find someone who also wants to assume ownership of your property. Therefore, most people must perform delayed, three-party or Starker exchanges.
After selling their relinquished property, the seller must identify a like-kind replacement property within 45 days and purchase it within 180 days. However, the seller cannot hold onto the funds during that period. In its place, the IRS requires the presence of a qualified intermediary.
Choosing a Qualified Intermediary for a 1031 Exchange
There are hundreds of qualified intermediaries and QI companies in the United States to choose from. You can find potentially qualified intermediaries for your 1031 exchange by using the following methods:
- Consult your local escrow officer for recommendations.
- Ask your network of fellow investors for references.
- Registering QIs (qualified intermediaries) with regulatory groups, including the Federation of Exchange Accommodators, in national directories.
In spite of the fact that these methods can provide you with plenty of options for qualified intermediaries, the most crucial question isn’t how to find one, but how to select one.
What to Look for in a Qualified Intermediary
In a 1031 exchange, there’s a lot on the line due to the amount of money involved and the complicated regulations. Choosing the right qualified intermediary
(QI) is, therefore, crucial. Create a short list of a few options, then work with your tax adviser and other trusted financial advisers to identify the most qualified intermediary. When considering your options, consider the following points.
- Experience Level
A potential qualified intermediary’s experience and track record are the first things you should consider. It is wise to understand what QI-qualified intermediaries know and how well they have performed before hiring them. Most QIs have extensive knowledge of 1031 exchanges and backgrounds in related fields. Topics to cover are listed below.
Experience: Determine how long they have been doing 1031 exchanges and how many they have completed. Some example questions include: “How long have you worked with 1031 exchanges?” “What was your most challenging exchange?” “How many 1031 exchanges have you done?” “Why do investors choose you over other intermediaries?” and “What is the most memorable mistake you’ve ever seen?” The longer the QI (qualified intermediaries) has been in business, the better.
Full- or part-time status: Some QIs (qualified intermediaries) work on exchanges as part-time side gigs. In the case of more complicated property swaps, you’ll want someone whose livelihood is at stake if something goes wrong, and someone who devotes their time to executing these transactions.
Complex exchanges: It’s smart to know how comprehensive your qualified intermediary’s experience is, even if it’s a relatively simple exchange. Inquire whether they have done complex exchanges, construction exchanges, and reverse exchanges in the past. Having a qualified intermediary with experience in complex transactions means you can trust their thorough understanding of 1031 regulations even if you are not performing this type of property swap.
Licensure and designation: While some states require licenses for qualified intermediaries, working with an intermediary who has earned licensure or certification, even if they aren’t required.
Ask qualified intermediaries for the average dollar amount of exchanges they have performed over the last few years when interviewing them. Ideally, you should choose an intermediary with experience handling transactions of the same size as what you want to do.
- Insurance, Bonds, and Funds Management
A crucial aspect to consider is the financial aspect. The following factors should be discussed with potentially qualified intermediaries.
Holds fidelity bonds: QIs should have at least a $1 million fidelity bond. They provide protection to businesses from theft and dishonest behavior, such as if an employee of the QI’s company steals from an escrow account.
Errors and omissions coverage: Your exchange is protected if a qualified intermediary’s paperwork error causes it to fail because of errors and omissions. A qualified intermediary cannot collect damages on your behalf; the insurance company can.
Fund separation: Ensure your funds are not mixed with other clients’ funds. While this is uncommon, it is a valid question to ask, as this prevents your money from being seized if the QI declares bankruptcy during the exchange process. All qualified intermediaries should hold funds in separate trust or escrow accounts in FDIC-insured banks.
Depending on the laws and requirements in each state, not all qualified intermediaries will maintain the coverage and procedures listed above. However, you should work with a qualified intermediary who meets these basic standards regardless of state regulations. In the event of theft or clerical errors, hiring an unbonded or uninsured qualified intermediary could result in major losses.
- Customer Service
Your potential qualified intermediary should also provide quality customer service and be responsive. In order to assess this, you can use a variety of methods.
Direct interactions: When contacting a qualified intermediary, note the time it takes for them to respond. You will want a QI who quickly responds to requests and answers questions thoroughly. The preferred methods of contact and the average response time of a QI are especially important if you are working over a long distance and cannot meet face-to-face. A good intermediary will be eager to provide instructions if you perform your first 1031 exchange. You should also find out how helpful they are and their willingness to consult with you.
Reviews and references: A qualified intermediary with industry experience will likely have reviews and references. You should check online reviews whenever possible and ask for references from a potential intermediary. You should be wary of qualified intermediaries who cannot provide references or testimonials.
- Costs and Fees
Costs and fees are the final factors when choosing a qualified intermediary. Finding a qualified intermediary with the experience and coverage your exchange requires is crucial.
Most qualified intermediaries charge between $700 and $1,100 per transaction for typically delayed exchanges. However, the price will likely increase if you exchange more complexly. Compared to a delayed exchange, a reverse exchange involves purchasing a replacement property before selling the old one. The costs of construction exchanges are even higher, ranging from $6,000 to $10,000. According to the property values, the number of parties and properties involved, and other factors, these fees may increase.
To get an accurate price estimate, get quotes from multiple qualified intermediaries.
You should use this process if you are doing a more complex exchange. As with any service, a qualified intermediary whose quote is significantly lower than the average should be avoided.
Ask about additional fees for wire transfers, title transfers, and rush services in addition to the base price. In order to prepare for these, it is crucial to understand them in advance.
1031 Exchange Rules and Requirements
Anyone looking to perform a 1031 exchange for the first time may find the rules and requirements overwhelming. We’ve compiled the most important elements so that you can quickly familiarize yourself with the vocabulary and standard questions that a Qualified Intermediary will ask.
For a 1031 exchange to be valid, all rules and guidelines must be followed from start to finish. Depending on whether you’re selling residential or commercial property, the state where you live, and when the property is sold, there may be different requirements.
Tax return and titleholder on the title of a property that sells must match those on the title of the property that buys. Single-member limited liability companies (SMLLCs) are considered pass-through entities. Due to this, SMLLCs can sell, and members can purchase on their own behalf.
Property Identification Timeline
Exchangers have 45 calendar days after closing on the first property to identify the addresses of potential replacement properties to either the accommodator or closing entity. Reverse exchanges require the exchanger to submit a final list of properties for sale or purchase 45 days after either the replacement or relinquished property has been parked.
Three property rule – can identify any three properties regardless of value.
Identifying four or more properties is possible as long as the value does not exceed 200 percent of the sold property.
There is an exception rule of 95 percent – if the value exceeds 200 percent, 95 percent of what is identified must be purchased.
Property must be purchased within 180 calendar days following the closing of the first property – or an extension of the exchanger’s tax return if the relinquished property closes after October 15th.
In order to defer 100 percent of the tax, the net sales price of the property sold must be equal to or greater than the net sales price of the replacement property. Alternatively, the exchanger must pay tax on the difference, known as a partial exchange. Replacement property debt and equity must equal or exceed debt and equity in the relinquished property. A replacement property with additional equity or cash offsets debt. Equity is not offset by additional debt.
Fact Patterns and Intent
Although there is no hold time in the 1031 code, the Internal Revenue Service examines whether the property was acquired immediately before the exchange. Does it need to be fixed and flipped, or is it to be held for productive use or investment? Intentions to hold for investment are supported by a number of factors. Facts supporting the intent should be more substantial the shorter the timeframe. The property should also be listed on Schedule E or Schedule A. Investment properties are listed on Schedule E. Was the property rented? Does the amount of personal use exceed 14 or ten percent of the rental overnights? A second home may resemble the character if this is the case.
“Related person” or “related party” means any person or entity with a relationship to the taxpayer as defined in Section 267(b) or Section 707(b)(1) of the Internal Revenue Code (IRC), including:
- Siblings, spouses, ancestors, and lineal descendants of the same family
- A corporation owned directly or indirectly by or for a single individual with more than 50 percent of the stock value
- Two (2) corporations that are in the same controlled group (as defined in subsection (f))
- Trust grantors and fiduciaries
- A fiduciary of one trust and a beneficiary of another trust where the same person is the grantor of both trusts
- A fiduciary of a trust and a beneficiary of the same trust
- One or more trusts or their grantors or fiduciaries own more than 50 percent of the stock value of a corporation
- As defined in Section 501 of the Internal Revenue Code (IRC) (pertaining to educational or charitable non-profit organizations), an organization is controlled directly or indirectly by an individual or, if that individual is an individual, by a family member.
- Corporations and partnerships owned by the same person or persons:
- More than 50 percent in value of the outstanding stock of the corporation, and
- In a partnership, more than 50 percent of the capital interest is owned by the profits interest
- An S corporation and another S corporation or a C corporation if the same person or persons own more than 50 percent of each corporation’s outstanding stock
- Partnerships and persons own more than 50 percent of the partnership’s capital or profits directly or indirectly.
- Two partnerships in which the same person owns more than 50 percent of the capital or profits of both
- Beneficiaries and executors of an estate.
- A testamentary trust created by a husband and an inter vivos generation-skipping trust created by a wife are not related because the trusts did not have the same grantor per Private Letter Ruling 9224008. Investors may be able to eliminate related party transaction issues by changing the ownership of the related party; the related party’s ownership interest can be reduced below 50 percent by transferring or disposing of an interest in a partnership or shares in a corporation to an unrelated third party.
- The constructive ownership rules under Section 267(c) of the Internal Revenue Code apply in determining the ownership of stock, capital interest, or profits interest.
Related Party Transactions
In a related party 1031 exchange, you sell your relinquished property to a related party or buy your like-kind replacement property from a related party. If you follow specific rules and guidelines issued by the Internal Revenue Service, related party 1031 exchanges are permitted.
If the old property is sold to a related party, the tax-deferred by the 1031 exchange must be paid within two years of the sale. Replacement property can only be purchased from a related party initiating a 1031 exchange.
Related party relationships can also be eliminated altogether before structuring and completing the 1031 Exchange transaction. A related party includes, but is not limited to, immediate family members, such as brothers, sisters, spouses, and ascending and descending lineal descendants. Ex-spouses, stepparents, uncles, aunts, in-laws, cousins, nephews, nieces, and cousins are not considered related parties.
Related parties include corporations, limited liability companies, and partnerships in which the taxpayer owns more than 50% of the stock, membership interests, partnership interests, or more than 50% of the capital or profit interests.
An individual’s lineal descendants are his children, grandchildren, and so on, down the line.
Below we have provided details on each rule of a 1031 exchange if you have any more questions about how exchanges work.
Types of 1031 Exchanges
The Main 4 Types of 1031 Exchanges: Investors can use one of these four common 1031 exchange methods when relinquishing real property for new assets: 1. Two-Party Simultaneous Exchange
Exchanges are the oldest of these four 1031 exchange methods. Two property owners agree to swap deeds and ownership interest of their properties. Although this method eliminates the need to find buyers, it usually takes more work for exchangers to find fair-market-value properties with matching debt and equity structures. Exchangers may also be seriously liable if the ownership transfer is delayed.
- Delayed Exchange
Delayed exchanges are the most common 1031 exchanges. Exchangers have 45 days to identify a like-kind replacement property and must close on the property within 180 days. These two timelines are usually non-negotiable with the Internal Revenue Service; however, the IRS issued Notice 2020-23, which extended these deadlines in certain instances due to the COVID-19 pandemic.
- Reverse Exchange
Before fully relinquishing current assets, exchangers acquire the like-kind replacement property. In order to take possession of their relinquished or target assets simultaneously, exchangers must have an Exchange Accommodation Titleholder (EAT) temporarily take possession of the relinquished or target assets via a special purpose entity, such as a single-member LLC. Through a Qualified Exchange Accommodation Agreement, the EAT takes possession of the relinquished or target property.
- Construction/Improvement Exchange
The exchangers can use the equity generated by the exchange to improve a target asset. Real estate exchanges can either refurbish, make capital improvements to existing properties, or build new ones from the ground up. An improvement exchange can significantly increase a property’s value.
Nevertheless, the improved or new replacement property must have the same value as the relinquished property. In addition, 45- and 180-day deadlines still apply, which can complicate this exchange transaction since exchangers have just under six months to complete all capital improvements.
Other 1031 Exchange Strategies
The IRS limited like-kind exchanges to real property with the passage of the Tax Cuts and Jobs Act, effective January 1, 2018. Personal property exchanges previously allowed exchangers to include assets such as aircraft, boats, machinery, or equipment.
Capital gains taxes can be deferred with each exchange method, while passive income can be generated. Before initiating the 1031 exchange process, real estate investors should carefully analyze each option’s pros and cons. Each exchange method has its own intricacies and opportunities.
Simultaneous 1031 Exchange
A simultaneous 1031 exchange is a real estate transaction where the sale of one property and the purchase of another occur simultaneously. Both properties must qualify for a 1031 exchange, which allows the investor to defer paying capital gains taxes on the sale of the first property by reinvesting the proceeds into the second property. While the sale and purchase timing must align, this type of exchange can also be streamlined and efficient.
Reverse 1031 Exchange
An investor who performs a reverse 1031 exchange acquires a replacement property before selling their relinquished property. As part of a standard 1031 exchange, the investor sells their current property and purchases a replacement property with the proceeds. In a reverse 1031 exchange, the sequence is reversed, with the replacement property being purchased first, typically through an exchange accommodation titleholder (EAT). Within a specific timeframe, the relinquished property is sold.
To comply with IRS regulations, a qualified intermediary and other professionals should be consulted for reverse 1031 exchanges. However, they can be a useful strategy in situations where a desirable replacement property becomes available before the investor is able to sell their current property.
In an improvement exchange, also known as a build-to-suit exchange, the replacement property does not yet exist at the time of the exchange. The investor identifies a piece of land and contracts with a qualified intermediary and a construction company to construct a replacement property that meets his or her specific needs.
The investor constructs the replacement property using the proceeds from the sale of the relinquished property. In a 1031 exchange, the construction must be completed within 180 days. The investor takes ownership of the replacement property after the construction is complete.
Investors who cannot find a replacement property that meets their needs or want to customize their replacement property to maximize its value may consider improvement exchanges. To ensure compliance with IRS regulations, improvement exchanges must be planned and coordinated with a qualified intermediary, construction company, and other professionals.
Do Banks Offer 1031 Exchanges?
1031 exchanges are not generally offered directly by banks. Investors typically work with a qualified intermediary (QI) to facilitate the exchange. Qualified intermediaries hold the proceeds from the sale of the relinquished property and use them to purchase the replacement property, allowing the investor to defer capital gains taxes.
Banks can provide financial services related to the exchange, such as holding funds for qualified intermediaries, but they cannot act as qualified intermediaries themselves. Because of the IRS’s requirement, the qualified intermediary must be an independent party without any existing relationship with the taxpayer, such as a bank or a real estate agent.
Ensure that your exchange is executed properly and complies with IRS regulations by working with an experienced, reputable, qualified intermediary.
How a 1031 Exchange Works in the Real World (Example)
Suppose a real estate investor purchased a commercial property for $500,000 several years ago. The investor estimates the property is worth $1 million now after the property has appreciated in value over time. The investor would have to pay capital gains taxes on the $500,000 increase in value if they sold the property outright.
The investor decides to do a 1031 exchange instead of selling the property and paying taxes. They found another commercial property for $1.2 million that they would like to purchase. The investor works with a qualified intermediary (QI) to facilitate the exchange, as the IRS requires that the proceeds from the sale of the original property be held by a QI until the purchase of the new property is complete.
The investor sells their original property for $1 million and uses the entire amount as a down payment on the new property. They obtain financing for the remaining $200,000. Capital gains taxes on the $500,000 increase in value from the original property can be deferred since the sale proceeds were used to buy the new property.
Investing in a new, higher-value property could generate more income for the investor. Until they sell the new property, they have deferred their tax liability. To ensure a successful 1031 exchange, working with a knowledgeable tax professional and qualified intermediary is imperative.
Selling real estate without using a 1031 exchange
A seller who sells real estate without a 1031 exchange will have to pay capital gains taxes on any profits from the sale. The tax burden could be significant depending on the time the seller held the property, the profit, and the seller’s tax bracket. However, some sellers may not use a 1031 exchange for various reasons, including needing the cash from the sale immediately or not finding a suitable replacement property within the exchange period. Alternatively, the seller may invest the remaining proceeds in other opportunities after paying the taxes. Before deciding, sellers should consider all their options and consult a tax professional.
Selling real estate using a 1031 exchange
Using a 1031 exchange to sell real estate is a tax-deferred transaction that allows the seller to defer paying capital gains taxes on the sale. Instead of paying taxes immediately, the seller can use the proceeds from the sale to purchase a like-kind replacement property within a specific time period. This can be a valuable tool for real estate investors looking to sell their current property and reinvest the proceeds into a new property while deferring taxes on their gains. However, it’s important to note that the 1031 exchange process can be complex and requires adherence to specific rules and regulations. Working with a knowledgeable tax professional and qualified intermediary is crucial to ensure a successful exchange.
The Pros and Cons of Using a 1031 Exchange
Using a 1031 exchange for a real estate transaction has several advantages and disadvantages. Consider these key benefits and drawbacks:
Tax Deferral: One of the primary advantages of a 1031 exchange is deferring capital gains taxes on the sale of the property. You can reinvest cash in a new property by freeing up cash, potentially increasing your profits.
Increased Buying Power: Deferring taxes gives the seller more buying power and increases the potential for appreciation and cash flow.
Diversification: By investing in a broader range of real estate assets, investors can diversify their portfolios.
Estate Planning: With a 1031 exchange, investors can also pass ownership of their properties on to their heirs, potentially reducing or eliminating their estate taxes.
Limited Timeframe: A 1031 exchange must be completed within 45 days of selling the original property, and closing must occur 180 days after buying the replacement property.
Replacement Property Availability: It can take time to locate a replacement property that meets the exchange criteria, especially in competitive markets.
Complex Process: Complying with specific rules and regulations is a requirement of the 1031 exchange process. To ensure compliance with IRS guidelines, working with a qualified intermediary and knowledgeable tax professional is important.
Tax Burden in the Future: 1031 exchanges can defer taxes but do not eliminate them. If another 1031 exchange is not completed, the tax liability will eventually become due when the replacement property is sold. Real estate investors can benefit from a 1031 exchange in several ways, including deferred taxes, increased purchasing power, and portfolio diversification. Before making any decisions, it is important to carefully weigh the pros and cons of the process carefully.
In Conclusion: Things to Remember about 1031 Exchanges (Bottom line)
In conclusion, here are some key things to remember about 1031 exchanges:
A 1031 exchange is a tax-deferred transaction that allows real estate investors to defer paying capital gains taxes on the sale of their property. The exchange must involve like-kind properties, meaning that the replacement property must be similar in nature, character, and use to the sold property. The seller must identify a replacement property within 45 days of selling their original property, and close on the new property within 180 days. Working with a qualified intermediary and a knowledgeable tax professional is crucial to ensure compliance with IRS guidelines.
A 1031 exchange can provide several benefits, including tax deferral, increased buying power, and diversification. Still, there are also some drawbacks, including a limited timeframe, the availability of suitable replacement properties, and the complexity of the process.
It’s important to carefully consider the pros and cons of a 1031 exchange and consult with professionals before making any decisions about buying or selling real estate.