Thanks to IRC Section 1031, a properly structured 1031 exchange allows a real estate investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states: “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.” To understand the powerful protection a 1031 exchange offers, consider the following example:

  • Assume a real estate investor has $400,000 in gain and also $400,000 in net proceeds after closing. Assuming a real estate investor with a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another replacement property.
  • Assuming a 25% down payment, and taking on new financing for the purchase with a 75% loan-to-value ratio, the investor would only be able to purchase a $1,040,000 replacement property.
  • If the same investor chose to perform a 1031 exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.

As the above example demonstrates, 1031 tax-deferred exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the Section 1031 tax code. Asset Preservation, Inc. (API) is your resource to obtain accurate and thorough information about the entire exchange process.

WHAT IS LIKE-KIND PROPERTY?

IRC Section 1031 limits like-kind property to only certain types of real property. The term like-kind property refers to the nature or character of the property, rather than its grade or quality. Real property must be exchanged for like-kind real property. Furthermore, real property held for investment can be exchanged for real property used in a trade or business or real property held for use in a trade or business can be exchanged for real property held for investment. Personal property is not eligible for 1031 exchange tax deferral. Regarding real property, a taxpayer’s primary residence and property held primarily for resale or dealer property are excluded from tax deferral under Section 1031. Section 121 provides tax exclusion for a taxpayer’s primary residence held for two (2) of the past five (5) years.
Like-Kind Property Example

QUALIFYING REAL PROPERTY

The types of real property which can be exchanged under Section 1031 are very broad. Any real property held for productive use in a trade or business or for investment, whether improved or unimproved, is considered like-kind real property. Examples of like-kind real property include:

  • Unimproved property for improved property;
  • Fee for a leasehold with 30 or more years;
  • Vacant land for a commercial building;
  • Duplex for a retail property;
  • Single-family rental for a multi-family apartment;
  • Conservation easement for warehouse to be used in the taxpayer’s business;
  • Industrial property for rental vacation property in a resort area.

TYPES OF 1031 EXCHANGES

There are a number of different 1031 exchange variations including simultaneous, delayed, parking arrangements (reverse, improvement and reverse/improvement exchanges) but the most common variation is the delayed exchange.

THE DELAYED EXCHANGE

Delayed Exchange Process

Delayed Exchange Identification Period

A delayed exchange is the most common exchange format, providing investors the flexibility of up to a maximum of 180 days to purchase a replacement property. The use of a qualified intermediary is required to complete a valid delayed exchange. The qualified intermediary prepares the necessary exchange documents to assist the taxpayer in meeting the many detailed requirements of the Code, as well as avoiding numerous destructive pitfalls.

SALE OF THE RELINQUISHED PROPERTY

Prior to closing the sale of the relinquished property, the taxpayer enters into the Exchange Agreement with API. Pursuant to the Exchange Agreement, an Assignment is executed prior to closing, and API assumes the taxpayer’s Purchase and Sale agreement. API instructs the closing/escrow officer or closing attorney to directly deed the property from the taxpayer to the buyer. Proceeds are transferred directly to the qualified intermediary, thereby protecting the taxpayer from actual or constructive receipt of funds.

IDENTIFICATION OF REPLACEMENT PROPERTY

The taxpayer must properly identify potential replacement properties within 45 calendar days. API provides the taxpayer with the specific identification requirements, one of which is that the identification must be made in writing and the property must be unambiguously described. The three rules of identification are:

  1. Three Property Rule: A taxpayer may identify a maximum of three (3) replacement properties, without regard to the fair market value of the properties.
  2. Two-Hundred Percent Rule: The taxpayer may identify any number of properties as long as the aggregate fair market value does not exceed two hundred percent (200%) of the aggregate fair market value of the relinquished property.
  3. Ninety-Five Percent Exception: The taxpayer may identify any number of properties without regard to the combined fair market value, as long as the properties acquired amount to at least ninety-five percent (95%) of the fair market value of all identified properties.

PURCHASE OF THE REPLACEMENT PROPERTY

The taxpayer has a total of 180 calendar days from the closing of the relinquished property, or their tax filing date, whichever is earlier, to acquire like-kind replacement properties. Prior to closing on the replacement property, the taxpayer assigns the Purchase and Sale Agreement to the qualified intermediary. After the Assignment is executed, the exchange is completed when the qualified intermediary purchases the replacement property with the exchange proceeds and transfers it back to the taxpayer by a direct deed from the seller.
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