Taxes! The entire reasoning behind doing a §1031 Exchange is to defer the taxes you typically paid on capital gain and depreciation recapture when selling a property held for investment or business/trade purposes. The idea is to reinvest 100 cents on your dollar of proceeds, rather than paying tax (often 30 cents on the dollar or more) to the IRS and reinvesting the rest (70 cents). §1031 allows taxpayers to grow their money faster by preserving principal through the deferral of tax.
The reason for NOT doing an exchange is the same for doing an exchange…. Taxes! In this case however, the reason for not doing an exchange would be you did not have enough gain, therefore tax, to justify the cost of a §1031. Not to mention the necessity of locking that money up into an illiquid investment for an indefinite period of time. You’d be better off paying the small amount of tax and investing the remaining cash proceeds without the restrictions that come with §1031.
The most important requirements of successfully executing an exchange involve 3 elements: Who, What and When
- Who: Who or what (entity) is selling the relinquished property? Under the “Same Taxpayer Rule” the IRS requires that the taxpaying individual(s) or entity that sold MUST be the SAME taxpaying individual(s) or entity that purchases the replacement property(s). There are technical nuances to this rule that we can discuss in greater detail that may enhance the estate planning component of your §1031 strategy.
- What: What type of property is being sold? The IRS requires that both the property being sold (relinquished property) and the property being purchased (replacement property) must be held for investment or business/trade purposes. There are nuances to this rule as well that we can discuss in greater detail that may expand your options if handled properly.
- When: When are you selling and when must you purchase? The IRS has strict time requirements that §1031 Exchanges must abide by if they are to successfully complete the exchange. Here are the two main ones:
- ~45-Day Identification Period: You have 45 days from the closing date of your relinquished property to identify in writing with your Qualified Intermediary the property or properties you wish to consider purchasing with the relinquished value of your sale.
- ~180-Day Closing Period: You have 180 days from the closing date of your relinquished property to close upon some or all the property or properties you wish to purchase with the relinquished value of your sale.
If you close on the sale of your relinquished property between October 15th and December 31st you will need to file for an extension on your tax returns IF you cannot close on your replacement property(s) prior to April 15th, as that day is 180 days from October 15th. A technical formality, but important nonetheless.
Yes, raw land can be sold and/or purchased and qualify under §1031.
No, taxpayers always have the option to do a partial exchange by reinvesting a portion of the relinquished value of the property they are selling. However, in doing so, they will likely pay tax on the unreplaced amount of value up to their tax basis.
If you exceed your 45th day without having formally identified replacement property with your Qualified Intermediary (QI) you will have officially “failed” your exchange and trigger a tax lability. Depending on your QI’s protocol, you will receive the exchange funds held in your exchange account after the 45th day. However, before hiring a QI you’ll want to verify how they handle the disbursement of §1031 proceeds.
Yes, depending on the timing of the two relinquished property sales, you can aggregate multiple §1031 Exchanges and invest in one replacement property. Increased buying power often improves the quality of the tenants, asset types and lease structures you can consider. Combining multiple exchanges into one large purchase is often of interest to exchangers looking to upgrade their real estate holdings.
Yes, however it will take strategic thinking and planning before selling your property. The “same taxpayer” rule within §1031 requires that Partnerships must exchange into replacement property with the identical ownership structure to that of the relinquished property. However, life happens and not all partners want to continue investing together. There are ways to preserve each partner’s individual monetary interest in the sale to allow a separation before or after closing.
Ideally, having as much time prior to the sale to coordinate while working together, the better. Also, feel free to learn more by searching “swap and drop” and “drop and swap”. This will help you understand several options you have in exercising this option.
No, taxpayers cannot do a §1031 Exchange using real property, relinquished or replacement, outside of the United States.
This is one of the most common misunderstood facts about §1031 Exchanges. No, the IRS has no definitive guidance as to how long an investor/business owner must have owned their relinquished property prior to doing a §1031 Exchange. However, what the IRS does care about is “intent”. What was the Taxpayer’s intent in holding that property? Time is often a good measuring stick of intent, but not the only one. We can discuss this in further detail to make sure the property you are considering selling will qualify under §1031.
A Qualified Intermediary or Exchange Accommodator is a 3rd party agent that takes possession of the exchange proceeds from the property closing and holds the funds while you decide where to invest them next. There are large national QI services and smaller local or regional QI services, however, not all are created equal. It is important that whichever QI you select is bonded, insured and does not commingle the exchange funds of their clients.
Services tend to cost $850 - $1,250 depending upon the number of relinquished and replacement properties involved within the exchange. And YES, you need one as Exchangers are required by the IRS to use a QI under §1031.
While both tax strategies provide the Taxpayer with a deferral of capital gain, there are important differences to understand between using a §1031 Exchange and investing in an Opportunity Zone (O-Zone). Here are ONLY a few:
- Tax deferral under §1031 only applies to gains associated with the sale of real property used for investment or use in business or trade. Investing in an opportunity zone provides a defer of any qualified gain, including gain triggered from the sale of stock.
- Under current tax law, Taxpayers can defer tax indefinitely under §1031, while taxes deferred through an O-Zone expire on December 31, 2026. Subsequently, whatever gain has been deferred will also become due in that tax year.
- In order for the Taxpayer to defer 100% of their capital gain tax under §1031, they must purchase an equal or greater amount of real estate value than what was sold. Whatever amount of relinquished value they do not replace in new property they will pay tax on (up to their basis).
For an O-Zone investor to defer tax, they must only invest an amount equal to the gain they wish to defer. For example, if they have $100,000 of qualified gain from the $300,000 sale of real estate or stock, they will only need to invest $100,000 to defer 100% of the gain. This differs from §1031, where the Taxpayer would be required to revest all $300,000 to defer 100% of the tax.
No, a common mistake Exchangers make is thinking they need only invest the cash from the sale of their property. “Equal or greater” refers to the value of the relinquished property. This is typically the sales price, minus any qualified exchange expenses (i.e. broker commissions, attorney fees, etc.).
For example, if a Taxpayer sells their relinquished property for $300,000 and had closing costs of $20,000, they will need to acquire $280,000 or greater of replacement property value to defer 100% of the tax. They can do that by sourcing replacing debt paid off at closing or adding cash to the purchase(s) of the replacement property(s).
