What is a 1031 Exchange?
By Austin Merk, Staff Accountant, Maloney + Novotny
If you are considering selling investment property only to buy other investment property, you should know about IRS code section 1031 and how you can utilize this to defer otherwise taxable gains. In summary, a 1031 exchange is a method used to defer gains on real property either used in a trade or business or as investment property. This is accomplished by timely reinvesting sales proceeds into other real property either used in a business or as an investment property, is like kind in value and is an equal or greater value of the relinquished property.
In addition to the ability to defer otherwise taxable gains, there are a multitude of reasons to employ a 1031 exchange. You can diversify your assets, such as swapping an apartment building for undeveloped land or vice versa. You have the ability to alter the total overall number of properties you own by exchanging one property for multiple properties that combined are of similar value to the original property relinquished. You can even use a 1031 exchange potentially to eliminate taxing the gain if held until included in the taxpayers estate.
What type of properties qualify for a 1031 exchange? That list of real property includes land, residential and commercial buildings, mineral interests, and even certain leaseholds. You must be cautious that you are not involving unqualified property in the process such as a taxpayer’s residence, partnership interest, or personal property. Cash and other financial instruments may be involved in the exchange along with the like kind property, however.
There are three primary methods utilized for a 1031 exchange; a swap, a deferred exchange, and a reverse (or parking) exchange. A swap is the most basic and straightforward method. The exchange happens simultaneously and there is no gain or loss recognized in the exchange. Cash and other financial instruments can be involved but the key is basis being equal. The next method is the deferred method, which is more common in the real world due to all the circumstances and requirements needed to be met for a 1031 exchange. The replacement property is identified and acquired after the sale of your property. During the process of identifying and acquiring the new property, the funds are held by a qualified intermediary or “QI” (typically a bank or a title company) that is independent of all other parts of the transaction. You have 45 days from the relinquished property sale to identify the replacement property and a total of 180 days to complete the purchase of the replacement property. On the other side of the deferred exchange timeline is a reverse exchange. This occurs when the replacement property is acquired first and then the original property is sold. After the property is purchased and prior to the sale of the original property the replacement property is held using a QEA (Qualified Exchange Agent) which is an unrelated party that is in control of transferring the titles once all requirements are met.
As mentioned previously, the taxpayer has 45 days to identify their replacement property in three different manners. You may identify three replacement properties regardless of their fair market value (FMV), but remember, to fully defer the gains you must replace your property with property that is at least an equal value to the relinquished property. The second option is to identify any number of properties so long as the aggregate FMV of those properties does not exceed 200% of the property being relinquished. The third option is to identify any number of properties, which can exceed 200% of the original FMV, as long as the taxpayer acquires at least 95% of the total value they identify. To identify the property, the taxpayer must provide the parcel number or street address of the property to the QI within the required time frame.
In nearly 100% of deferred and reverse exchanges, the relinquished and replaced properties will not be equivalent in value. In those cases, non-like-kind property will be surrendered or received in the exchange, commonly referred to as boot. The use of boot does not disqualify the exchange but rather introduces a potential taxable gain to the transaction. Boot may be in the form of cash or mortgage indebtedness. Any boot received is taxable in the same character as the proceeds had a Section 1031 exchange not been utilized.
In conclusion, IRS Code Section 1031 continues to be an effective tool for trades, businesses, and real property investors. Although it can be a complex process, those complexities allow for a great deal of flexibility. This is not a procedure for an investor acting alone. Competent professional assistance is needed at practically every step. Maloney + Novotny LLC has a wealth of experience managing the entire 1031 exchange process and can work with you to effectively meet and exceed your needs. Questions about 1031 Exchanges? Reach out to your Maloney + Novotny representative or use this online contact form.