1031 Exchanges
Legal Guidance for Tax-Deferred Property Transactions
Maximize your investment potential with legal advice for navigating 1031 exchanges and other tax-advantaged transactions seamlessly.
Tax Advantage with 1031 Exchanges
Successful real estate investment usually results in capital gains and income, both of which are taxed, at least federally. But, within the federal tax code and other sources of law, certain qualifying transactions are given favorable treatments including but not limited to reduced tax rates, accelerated depreciation, deferred tax payment, and other incentives. Collectively, these types of transactions are referred to as “tax-advantaged” because, compared to comparable but non-qualifying transactions, they will be more profitable for the parties involved due to their favorable tax treatment.
A classic example is the 1031 Exchange. Named for the tax code section it is found in, these transactions allow investors to sell real property and use the sales proceeds to purchase replacement property without realizing capital gains—The gains are deferred instead. In this article, we introduce the basics of how to use 1031 Exchanges.
Understanding a 1031 Exchange
In many ways, a 1031 Exchange allows an investor to sell one property and buy another while deferring capital gains taxes. A Qualified Intermediary (QI) holds the sale proceeds in trust and transfers them for the replacement property. The investor must identify a replacement property within 45 days and complete the purchase within 180 days. Variations like Reverse Exchange and Drop and Swap exist, but all variations have the same general eligibility requirements.
How to Preserve Eligibility for 1031 Exchange?
The Internal Revenue Service (IRS) has strict rules for 1031 Exchanges. To preserve eligibility, property owners need to meet specific criteria and follow certain timelines:
1. Like-Kind Property
Like-kind property refers to assets of the same nature, character, or class that can be exchanged without recognizing capital gains or losses under IRS Section 1031. But this can be a low bar. In the case of rental properties, it is usually sufficient for both real estate assets to have been purchased for investment purposes.
2. Investment or Business Property
The IRS defines eligible like-kind property as any property used for investment, trade, or business purposes. So, concerning real estate, this means properties used by the seller personally, such as a primary residence, do not qualify. Note, however, it is possible to apportion, or split, the value of a sold property that had mixed uses with the value attributable to qualifying uses remaining eligible.
3. Timeline and Identification of Property for Exchange
Within 45 days of selling a property, the property seller must list potential replacements. Up to three properties, or more properties worth no more than 200% of the sale price, may be selected. Note, purchasing a property during this period counts toward the limit, even if it is not listed. In a Reverse Exchange, like the name suggests, this timeline works in reverse. First, the property owner purchases the replacement, then they may the identification and sell their original property.
4. Same Name Requirement
The name on the title of the initial property being sold must match the title for the reinvestment property. This requirement can be especially important to keep in mind for larger real estate portfolios with complex ownership structures.
5. Engagement of a Qualified Intermediary
A QI in a 1031 Exchange is a neutral third party who facilitates the exchange of like-kind properties. The QI holds the proceeds from the sale of the relinquished property and uses them to acquire the replacement property on behalf of the investor. The investor hires the QI, .and the funds the QI holds between the sale of one property and the purchase of the other are held in trust. Note, under some circumstances, funds can also be used for development costs after replacement property acquisition.
6. Reinvestment of all Equity
All proceeds from the sale of the relinquished property must be used to acquire the replacement property. If any portion of the proceeds is not reinvested, it becomes taxable as “boot,” which includes both cash retention and debt reduction.
7. Purchase Timeline
Replacement property purchases must be completed within 180 days of selling. Longer periods may apply for completing some developments. Note, like the identification timeline, this timeline is reversed in a Reverse Exchange. Day 1: The investor identifies and purchases the replacement property before selling their current property. Day45, the investor identifies the property they plan to sell (the relinquished property) Day 180 the investor sells the relinquished property and completes the exchange.
Plan Your Transaction
Tax-advantaged transactions, like 1031 Exchanges, can be powerful tools for optimizing your real estate investment. Contact Cascade Counsel today for consultation and transaction review to learn more about how a 1031 Exchange, or other tax-advantaged transaction, will work for you.
