A 1031 exchange (also known as a like-kind exchange) is a transaction that allows a taxpayer to defer the capital gains tax that would be due on a sale of investment real estate or real estate used in a business. A 1031 exchange allows real estate investors to defer the capital gains tax on the sale of the appreciated property if they reinvest the proceeds in a new property. While a 1031 exchange may sound simple in premise, there are specific rules that must be followed to completely defer the capital gains tax.
Overview of a 1031 Exchange in California:
Here are some important steps necessary for the 1031 exchange:
- You have 45 days from the close of escrow to identify a number of potential replacement properties.
- You have 180 days from the close of escrow to close on one of the properties identified in the first 45 days.
- At the close of escrow, we provide you with a proof of funds letter to make new offers easy.
- You must not take “constructive receipt of the funds” (if it goes to the seller’s bank account you pay taxes)
- You must purchase the same amount of real estate (or greater) as your net sales proceeds in order to avoid all taxes.
There are 4 potential taxes you may incur if you DO NOT do an exchange. Three on the gain and one on depreciation:
- Federal capital gains taxes (15%-20%)
- California state tax (9.3%-13%)
- Medicare surtax (3.8%)
- Depreciation recapture (25% of any amount depreciated)
Types of 1031 Exchanges
Forward 1031 Exchange
Whether you choose a simultaneous or delayed forward exchange, both have the same steps to complete. Upon selling your asset (relinquished property), you have 45 days to identify what asset (replacements property) you will be acquiring. Upon completion of the 45 days, you will have an additional 135 days to close escrow on the replacement property. The total transaction cannot exceed 180 days from the close of escrow on your relinquished property
Reverse 1031 Exchange
As its’ name states, a Reverse 1031 Exchange is where you acquire an asset (replacement property) first, then have 45 days to identify what asset (relinquished property) you will be selling. You will then have an additional 135 days to complete the sale of your relinquished property. Upon the close of escrow, you can either pay yourself back for the acquisition or pay off the loan used to acquire the replacement property prior to the selling of the relinquished property. To complete a Reverse 1031 Exchange, the taxpayer must “park” title to either the relinquished or replacement property with an Exchange Accommodation Title Holder (E.A.T). As your 1031 Exchange Accommodator, we generally act as the E.A.T.
Build to Suit or Improvement 1031 Exchange
A Build to Suite or Improvement exchange occurs when the Taxpayer wishes to make improvements to the replacement property utilizing the sale proceeds of the relinquished property. This type of exchange also requires an E.A.T during the improvements. The improvements must be identified within the 45-Day Identification Period and the title of the improved property must be passed to the Taxpayer within the 180-Day Exchange Period. When dealing with real estate, it is not necessary for the improvements to be 100% complete prior to the title being acquired by the Taxpayer. If the value of the improved property has been increased to an amount equal or greater than the value of the relinquished property, the title may be conveyed to the taxpayer. However, the conveyed property must be substantially the same property that was identified.
Qualifying for a 1031 Exchange
In order to qualify for a 1031 Exchange, the Relinquished and the Replacement Properties must both have been acquired and “held for” investment or for use in a trade or business. The amount of time that the property must be “held for” use in a trade or business is not specified in either the Code or the Regulations.
The position of the IRS has been:
If a taxpayer’s property was acquired immediately before an exchange, or if the Replacement Property is disposed of immediately after an exchange, it was not held for the required purpose and the “held for” requirement was not met.
There is no safe harbor holding period
For complying with the “held for” requirement. The IRS interprets compliance based on their view of the taxpayer’s intent. The intent is demonstrated by facts and circumstances surrounding the taxpayer’s acquisition of ownership of the property and what the taxpayer does with the property. The courts have been more liberal than the IRS on these issues.
Here are some examples of transactions
That should be considered to have the potential for a
finding by the IRS that the “held for” requirement has
not been met:
- The taxpayer acquires Replacement Property and immediately lists the property for sale. The IRS will interpret the intent to acquire the property for resale instead of for investment purposes.
- The taxpayer receives the Relinquished Property by deed from a partnership and immediately proceeds to sell/exchange it (aka “drop and swap”).
- The taxpayer acquires Replacement Property and immediately converts the property to a personal residence.
- The taxpayer acquires Replacement Property and immediately transfers the property to a corporation, partnership or LLC.
Trade for a Like-Kind Property
The following types of property generally WILL qualify as like-kind property:
- Single-family residences
- Multi-family residences
- Commercial office space
- Retail shopping centers or strip malls
- Industrial warehouses
- Vacant or undeveloped land
- Oil and gas interests
- Mineral rights
- Water rights
- Tenant-in-common (TIC) property
- Vacation rentals
- 30+ Year Leases
- Delaware Statutory Trust (DST) property interest
The following types of property will generally NOT qualify as like-kind property:
- Personal use assets
- Primary residences
- Second homes
- Vacation homes (personal use)
- Property held for sale
- Property held for development
- Property acquired for conversion, then sold
- Property acquired to fix-up and sell
- Mutual funds
- Interests in an Entity
- Partnership interests owned in a general or limited partnership
- Membership interests held in a limited liability company (unless it is a single-member LLC)
- Shares of stock in a corporation
As a result of the Revenue Reconciliation Act of 1989, real property located within the United States and real property located outside of the United States are no longer of like kind. However, foreign property may still be exchanged for other foreign property. Section 7701 defines the borders of the United States as all fifty states and the District of Columbia.
For purposes of the 1031 code, the Internal Revenue Service defined the borders of the U.S. to include the U.S. Virgin Islands given the Exchanger is: (1) A citizen or resident of the United States and (2) Has income derived from sources within the U.S. Virgin Islands, is effectively connected to the performance of a trade or business in the U.S. Virgin Island or files a joint return with an individual who derives an income or is connected to a trade or business within the U.S. Virgin Islands. Both requirements must be satisfied to exchange real property in the fifty states and real property located in the U.S. Virgin Islands. Puerto Rico is not eligible for 1031 eligibility while real and personal property located in Guam is eligible.
Revenue Procedure 2008-16 provides specific safe harbor language that clarifies when your vacation home, second home or primary residence that was converted to investment property would be considered as “qualified use property” and therefore qualify for 1031 Exchange treatment pursuant to Section 1031 of the Internal Revenue Code, although a safe strategy is to convert the second home into an investment property and rent out the property at fair market value for two years prior to the sale and exchange of the property. Alternatively, the owner could rent out their second home for a minimum of 14 days at fair market value and limit their own personal use to 14 days per year for the two years prior to the sale of the property or 10 percent of the number of days that the property is rented at fair market value during each year. The IRS has very specific definitions regarding personal use if for any part of a day the property is utilized by the owner. This includes the owner who has an interest in the second home or vacation property as a tenant-in-common interest. Furthermore, use by any member of the owner’s family counts as personal use days unless the second home or vacation property is rented out to those family members as a full-time principal residence at a fair market rent.
Another IRS requirement specifies that if the owner rents out the vacation or second home property at less than fair market value, the days rented will be considered personal use days. Lastly, an additional rule defines that any use by the owner who uses the property under an arrangement which enables them to use some other property is considered personal use.
With so many intricate IRS rules regarding vacation and second home properties, always check with your tax advisor.
1031 Exchange Timelines
The successful completion of a 1031 Exchange transaction requires you to comply with certain 1031 Exchange deadlines pursuant to Section 1031 of the Internal Revenue Code. The 1031 Exchange deadlines consist of the 45-calendar day identification deadline and the 180-calendar day 1031 Exchange completion period. These 1031 Exchange due dates cannot be extended, unless the President of the United States declares a natural disaster area that affects the properties or parties involved with the 1031 Exchange transaction.
45 Calendar Day Identification Deadline
When completing a 1031 Exchange transaction you must identify your potential like-kind replacement properties to your Qualified Intermediary no later than midnight of the 45th calendar day following the close of the relinquished property sale transaction. Holidays and weekends count. The formal identification should be made in writing to your Qualified Intermediary via email, facsimile, U.S. Mail, or overnight courier. You can change your mind by formally revoking the identification of your like-kind replacement properties and subsequently submit a new identification form at any time during your 45-calendar day identification period, but you cannot change your mind after the 45-calendar day identification period has expired. Revoking and submitting a new identification form does not change or reset the original 45 calendar day identification deadline. Failure to identify like-kind replacement properties within the 45-calendar day window will result in a failed 1031 Exchange transaction and the transaction becomes a taxable sale.
180 Calendar Day Exchange Period
You must complete your 1031 Exchange transaction, which includes the conveyance (receipt) of title to all of your like-kind replacement properties that you intend to acquire, no later than the earlier of:
- Midnight of the 180th calendar day following the close of the relinquished property sale transaction, Or
- The due date of your Federal income tax return for the tax year in which the relinquished property was sold, including any extensions of time to file.
You do not need to be concerned about part (2) above unless the first relinquished property transaction sold and closed on or after October 17th and on or before December 31st of any given tax year, which would mean that the 180th calendar day
would fall after April 15.
You will have less than 180 calendar days to complete your 1031 Exchange transaction if you have a 1031 Exchange transaction closing on or after October 17th and on or before December 31th of any given income tax year, unless you file for an extension of time to file your federal and, if necessary, state income tax returns. Once the extensions of time have been filed, you must complete your 1031 Exchange transaction within the 180 calendar days before you actually file your Federal and, if applicable, state income tax returns.
The 45-Day Rule for Identification imposes limitations on the number of potential Replacement Properties, which can be identified and received as Replacement Properties. More than one potential Replacement Property can be identified by one of the following three rules:
Three Property Rule
You can identify up to 3 separate properties regardless of their fair market value. This is the rule most commonly used.
You can identify as many properties as you prefer as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate fair market value of all of the
exchanged properties as of the initial transfer date. This rule is often used in exchanges where the taxpayer is selling one large asset or multiple assets and acquiring more than 3 assets. As an example, if a taxpayer were to sell a property for 1 million dollars, he/she could identify up to 2 million dollars in properties, regardless of how many properties that amount consisted of.
This rule allows you to identify any number of replacement properties at any value, but the fair market value of the properties acquired by the end of the 180 days must be at least 95% of the aggregate fair market value of all the potential replacement properties identified. This rule is used for large portfolio sales. It isn’t very common and can be risky.
What Can a 1031 Exchange Do for You?
Grow Your Real Estate Wealth Faster
A 1031 Exchange is a wealth-building tool, not just a tax code. Investors who are well-advised use this strategy to keep their wealth in their families. The concept is to exchange throughout your life, creating and keeping the wealth throughout one’s life. When you pass away, your family inherits the assets, and a full step-up in basis occurs. This means your family will inherit these assets and the tax liabilities are removed. A 1031 exchange is like a 401k for property – but you don’t have to wait until you’re 70 to enjoy your wealth!
Your “Qualified Intermediary” Is Crucial to Your Success
The person who helps you with a 1031 exchange is referred to by the tax code as a “qualified intermediary,” also commonly referred to as an exchange facilitator or intermediary. A “qualified intermediary” is basically a middleman who facilitates the transaction. “Qualified” does not refer to education or experience. So, you have to be careful who you use.
Don’t settle for a bargain-basement facilitator who will simply fill out the forms. You’ll save more and rest easier with the help
of a highly experienced facilitator.