WHAT IS A 1031 EXCHANGE?
Established real estate investors are likely already familiar with 1031 exchanges. The concept itself is simple: Reinvest the proceeds from the sale of a business or investment property into a like-kind investment in order to defer paying capital gains tax.
So how exactly does a 1031 exchange work? Say, for instance, you buy a property for $200,000 that is worth $500,000 by the time you sell it down the road. Rather than paying capital gains on the $300,000 the house has appreciated, a 1031 exchange would allow you to reinvest the proceeds from the sale into another piece of real estate.
Seems simple enough, right? Well, in reality, 1031 exchanges are much more complex. Section 1031 of the Internal Revenue Code (hence the name) has many nuances that can be daunting for first-timers. There are very specific guidelines governing the process. Here’s a brief overview of what you need to know about a typical 1031 exchange process.
The 3 Types of 1031 Exchanges
Deferred or Delayed 1031 Exchange
This is the most common type of 1031 exchange. In this case, the investor closes on the relinquished property; then, within 45 days (the “identification period”), they identify a replacement property. In order for a replacement property to be considered valid, one of three criteria must be true:
Three Property Rule: An investor identifies up to three different properties as potential purchases within the 45-day identification period, regardless of the total fair market value of the properties.
200% Rule: An investor may identify an unlimited number of replacement properties, as long as the total fair market value of all properties does not exceed 200% of the value of the relinquished property.
95% Rule: An investor may identify as many exchange properties as they want, as long as they receive at least 95% of the value of all identified replacement properties before the end of the exchange period.
In addition to the 45-day identification period, an investor only has 180 days from when they close on the relinquished property to close on the replacement property (the “exchange period”). These two dates are critical for investors to remember.
Finally, this type of 1031 exchange requires investors to use a Qualified Intermediary, also known as an “accommodator.” A QI is an uninvolved third party who holds the investor’s sales proceeds from the sale of their relinquished property in an escrow account until they close on the replacement property. If an investor were to touch the sales proceeds before closing on the replacement property, they would be in violation of Section 1031 and could be held liable for the taxes owed on those proceeds.
Simultaneous 1031 Exchange
The investor closes on the relinquished property, then closes on the replacement property immediately thereafter—usually within one day. An investor may use a Qualified Intermediary to handle the funds, but they’re not required to.
Reverse 1031 Exchange
The investor acquires a replacement property before conveying the relinquished property to the new buyer.
1031 Exchanges: Rules to Keep in Mind
As a general rule of thumb, investors should remember that the replacement property must be of equal or greater value (net of closing costs) than the relinquished property, and all exchange equity must be reinvested for the full tax deferral. To put it simply: trade up, and get no cash out.
In some instances, a 1031 exchange includes the transfer of property that is not considered a like-kind exchange. For example, the sale might include a cash payment to be used toward capital upgrades at the replacement property, which is called a “boot.” Because the cash is not considered like-kind property, the investor may be responsible for paying taxes on the “boot” portion of the exchange.
Meanwhile, a “mortgage boot” is when an investor reduces the mortgage liability on the replacement property below the mortgage liability on their relinquished property. Remember, the replacement property’s debt must be equal to or greater than the sold property’s debt. When a mortgage boot is present, an investor may have to add fresh cash to the transaction to offset the difference.