The 1031 Exchange name comes from Internal Revenue Code Section 1031. It enables you to defer capital gains tax and depreciation recapture by reinvesting the proceeds from the sale of investment property into replacement property, thus preserving significant wealth in your estate. Your 1031 exchange deferrals can be continued through as many exchanges as you wish. However, when you sell the property without reinvesting in a new property, there will be capital gains and depreciation recapture tax liability.
In addition, a 1031 exchange allows you to purchase a leveraged replacement property. This can increase your basis by the amount of additional real estate you purchase and potentially allows for additional depreciation pass-through. This can potentially shelter as much as 50% to 60% of the
A tax-deferred 1031 exchange can be a powerful wealth-building tool. However, we highly recommend you consult a professional tax advisor to ensure that you meet every requirement of Internal Revenue Code Section 1031. Failure to meet requirements can result in immediate tax liabilities and associated penalties. In addition, you must follow – to the letter – the strict timeline and procedural requirements for a proper 1031 exchanges.
Following requirements for 1031 exchanges to the letter is absolutely critical to realizing the investment benefits and avoiding costly penalties.
The exchange process must be facilitated by a Qualified Intermediary (QI), the professional who actually executes the exchange. QIs hold the proceeds from the property you sell until they are reinvested in the replacement property. There must be a written “exchange agreement” between you and the QI to prevent you from having “constructive receipt” of the funds during the exchange period. The QI is required to complete a valid 1031 exchange that ensures all roles are followed and equity is preserved during the process. Using a QI as an independent third-party to facilitate a tax-deferred exchange is a safe harbor established by Treasury Regulations, and it is very important for you to select a QI before closing on the sale of your property. We can work with any authorized QI of your choice, or we can suggest one who is fully bonded and has a national reputation.
The properties involved must be “like-kind". This requirement is liberally interpreted, and virtually all real estate properties, whether raw land or those with substantial improvements, qualify as like-kind. However, REITs, real estate funds or other securities do not qualify for 1031 exchange. Types of like-kind properties may include:
Retail Shopping Centers
You must follow strict identification and timeline rules for a 1031 exchange to the letter:
You must identify the exchange properties in writing within 45 calendar days of the closure for the relinquished property in accordance with one of the following rules:
Three-Property Rule: Identification of up to three properties regardless of the total value of property identified
200% Rule: Identification of any number of properties wherein the combined FMV (fair market value) does not exceed 200% of the relinquished properties’ FMV
95% Rule: Identification of any number of properties regardless of the aggregate FMV, as long as at least 95% of the property is ultimately acquired.
You must also close on the replacement property or properties within 180 calendar days of the closure for the relinquished property.
Other requirements include:
You must hold the properties for productive use in a business or for the purpose of investment.
The replacement property must be of equal or greater value than the property you sold.
The equity of the replacement property must be of equal or greater value than the equity of the property you sold. It is important to note that you CANNOT replace equity by acquiring more debt (with the exception of a 1033 Exchange).
The debt held by the replacement property must be of equal or greater value than the debt held by the property you sold unless you offset lower debt on the replacement property by adding cash to the exchange.
All net profit from the relinquished property must be used in the purchase of the replacement property otherwise you could have taxable consequences, sometimes known as “boot.”
DO Plan in advance. It’s the key to success in any exchange. Pay particular attention to the timing of the sale of the property you’re selling, estimating equity and debt replacement objectives to avoid boot, and retaining an expert QI (qualified intermediary).
DO Make every effort to sell before you purchase. If you identify an ideal replacement property before you sell, you may need to negotiate a reverse exchange (i.e., buying before selling). The IRS has guidance on this in Revenue Procedure 2000-37, but either the replacement property or the sale property must be parked with an Exchange Accommodator Titleholder for 180 days, pending the successful completion of the exchange.
DO Be mindful of the “napkin test” in a balanced exchange.
DON’T Miss your deadlines. The IRS will not honor the exchange if you miss the 45-day identification period or if you do not acquire the replacement property within the 180 day exchange period.
DON’T Change how
Risks of a 1031 ExchangeA 1031 exchange investment carries several risks, including but not limited to: