A 1031 exchange is an exchange of like-kind property meeting certain guidelines allowing sellers to defer the payment of taxes on the gains of the sale of the initial property. In a nutshell, property which has been used actively for productive business purposes (think rentals or business offices) can be sold and exchanged for different or better property to avoid–by deferral–recognizing gains on that transfer. The whole transaction is documented on IRS form 8824 for Like-Kind exchanges and governed by Internal Revenue Code section 1031 – thus, the name. Instead of paying taxes on the increase in value at the time the property is sold, that increase in value (“gain”) is held and passed on – it passes with the person, not the property. Very basically, the person holds on to the gain and carries it forward to the next property, allowing her to invest more of her money.
For instance:
- Sale: A four-unit apartment building is purchased for $1 million USD in cash and the basis, for simplicity’s sake, is $1 million. Five years later it is sold for $2 million. The seller owes capital gains tax (around 20%) on the $1 million increase in value since she purchased it; she has a tax bill this year of $200k. Instead of having $2 million to reinvest, she now has only $1,800,000.
- 1031 Exchange: The same apartment building with its $1 million basis is instead sold for $2 million and then exchanged for a $2 million qualifying beach rental property. If she puts nothing else down, the basis remains the same – $1 million – in the newly acquired property, but she gets to use the full $2 million in value, while deferring ALL of the gain from the initial property. She does not owe $200k in capital gains tax this year. The gain from the sale of the original (relinquished) property is “deferred” – which can be deferred indefinitely. This can allow her to generate much more wealth with purchasing power. If she were to put down $500k in cash and purchase a qualifying property worth even more, that amount would be added to the basis ($1.5 million in basis on the newly acquired property) which would allow access to larger properties as better investments.
To do this, you need:
- qualifying properties,
- an exchanger,
- the intent of a solid business purpose and plan (not “to avoid paying taxes,”),
- a qualified intermediary, aka “QI“, (someone who cannot have served as the seller’s real estate agent or broker, or attorney, or any number of other types of roles including accountant) in the last two years, and
- to meet a very specific and mandatory timeline.
Qualifying properties:
- generally, all real estate held for business use qualifies.
- it’s referred to “like kind” because there used to be many other types of property that could qualify, which went away circa 2018.
- beach houses used for renting for STRs qualify, even if you use it sometimes for yourself (check with an attorney to see specific details on this)
- farmland used for growing crops or rental
- apartments, condos, SFD homes used for rental purposes
- it cannot be your own personal property that you lived in / will live in on either end of the transaction, even if held in a disregarded but legally separated entity of some type.
There are three parties involved:
- the seller (the person taking advantage of the 1031), the exchanger, and the QI.
- the exchanger helps the seller, but there is a wall between the exchanger and the funds and property exchanges. (in fact, if the exchanger has access to the funds at all, the whole thing fails.)
- the seller has an agreement with the exchanger; the exchanger has an agreement with the QI.
- each party has her own very specific and important roles.
How the exchange itself works:
- the seller decides she wants to exchange property via 1031.
- the seller puts her property up for sale, aided by the exchanger.
- the QI steps in, in place of the exchanger, for the sale of the initial property.
- the QI receives the money from the initial property’s sale and transfers the deed to the new buyer.
- the QI places the sale money into a trust account pending the purchase of the new property.
- once her sale CLOSES, the 45 day window begins to run and she seller must identify a new property within 45 days and completely close within 180 days.
- once she identifies a new property that qualifies, with the help of the exchanger, she begins the purchase.
- the QI steps in, in the place of the exchanger, for the new purchase, and is named as the buyer on the closing statement of the replacement property.
- the QI pays for the new property, obtains the deed and transfers it to to exchanger, fully completing the 1031 exchange.
There are many things that can impact these qualifications and timelines, so it is very important to use parties who know what they are doing – attorneys, people with experience and licensure, and those with solid accounting for their trust accounts. Any one of these items that fails can destroy your 1031 or even an entire daisy chain of 1031s, potentially, and leave all gains fully recognized and taxable.
Final caveat: DO NOT RELY ON ANYONE FOR A 1031 EXCHANGE WHO DOES NOT FULLY UNDERSTAND AND WORK WITH TAX LAWS.
Resources:
- The 1031 Like Kind Exchange Form provided by the IRS:
- https://www.irs.gov/pub/irs-pdf/f8824.pdf
- Additional info from the IRS: https://www.irs.gov/pub/irs-news/fs-08-18.pdf
- A direct link to IRC section 1031: https://www.law.cornell.edu/uscode/text/26/1031
*Note: this is general information which can not be relied upon without knowing the specific details of your circumstances, which may cause the info to be inaccurate. You must consult an attorney for your specific case to be sure of your rights and obligations.