Guide to 1031 Tax-Deferred Exchanges

Involve a Qualified Intermediary

Once you’ve initiated a delayed 1031 exchange, you must retain a qualified intermediary (QI). A qualified intermediary is a person or company who manages the funds involved after a real estate investor sells their relinquished property and looks for a replacement. A QI has no stakes in the exchange and holds on to the proceeds from the sale of your property, then transfers the funds to the seller of the replacement property or properties.

The reason for using a QI is for them to act as a third party. The QI allows delayed exchanges and ensures the funds from the sale are compliant. This enables them to remain non taxable until the time limit for the 1031 exchange passes.

The seller has an identification window of 45 calendar days to identify a property to complete the exchange.

Once this window closes, the 1031 exchange is considered failed and funds from the property sale are considered taxable.

Due to this slim window, investment property owners are strongly encouraged to research and coordinate an exchange before selling their property and initiating the 45-day countdown.

Fortunately, investors have multiple identification strategies available, which are summarized in three rules:

Three Property Rule

Also known as the Three Property Identification Rule, the Three Property Rule enables investors to identify up to three like-kind replacement properties, whatever their fair market values are. After identification, the investor could then acquire one or all of the three identified like-kind replacement properties through the 1031 exchange process. This method is the most popular 1031 exchange strategy for investors, as it allows them to have backups if the purchase of their preferred property falls through.

200% Rule

The 200% of Fair Market Value Identification Rule states investors can identify an unlimited number of like-kind replacement properties, provided the total value of all properties at the end of the period doesn’t exceed 200% of the relinquished property’s total net sales value. 

If an investor wants to perform a 1031 exchange on a property with a sales value of $1 million, they can identify as many replacement properties as desired as long as those properties’ total value doesn’t exceed $2 million. This strategy is often preferred by investors looking to acquire over three investment properties or seeking extra backup properties if a sale falls through.

95% Exception

The 95% Identification Exception states investors can identify an unlimited number of potential replacement properties with an unlimited fair market value, provided the investor acquires and closes on 95% of the identified market value. This technique is most often used by investors who exceed the 200% rule at the close of the identification period. 

Using this exception may be an intentional choice if the investor seeks to purchase multiple properties. It may also happen inadvertently from sudden property value increases. Either way, this gets around the 200% rule while still meeting 1031 exchange requirements.

It’s important to note that if the investor fails to identify properties or identifies more properties than allowed by the Three Property Rule or the 200% Rule and cannot apply the 95% Exception, then the 1031 exchange is considered failed.

Once the replacement properties are identified within 45 days of selling the relinquished property, the seller has an additional 135 calendar days to purchase a replacement property to complete the exchange. Investors must purchase a replacement property or properties and have a qualified intermediary transfer the held funds within 180 days from the sale of the relinquished property.

This means they have to purchase a replacement property or properties and have the qualified intermediary transfer the funds by the 180-day mark.

This window may be shorter if the due date of the income tax return for the tax year in which the previous property was sold falls within the 180-day window. In which case, the sale is due by the tax return date.

If the deadline passes before the sale is complete, the 1031 exchange is considered failed and the funds from the property sale are taxable.

Another point of note is that the individual selling a relinquished property must be the same as the person purchasing the new property. The name must match between the tax returns and titles of the old and new properties for the exchange to qualify for the 1031 rule. The only exception to this rule applies to cases of single-member limited liability companies (SMLLCs).

The single-member limited liability company may be treated as equivalent to the sole member of the organization. For example, if John Smith is the sole member of JSmith Investments, LLC, he may sell a property under his name, purchase it under JSmith Investments, LLC and still qualify under the 1031 code, as they are considered equivalent entities.

The exchanger must hold the relinquished and replacement properties for productive investment use in business or trade. This means that only properties held for business or investment purposes may qualify for a 1031 exchange. This does not include personal properties, such as the seller’s primary residence. It also means that properties held solely for the purpose of selling, such as “flipped” properties, do not qualify for a 1031 exchange. There are some exceptions to this rule, however.

If you’ve heard of investment property owners using the 1031 provision to swap out vacation homes and residences, this is possible with some restrictions. As of 2004, Congress modified rules on 1031 exchanges so taxpayers must have used a residence as a rental property with tenants before selling it through a 1031 exchange. Although there is no set-in-stone timeframe, typically a residence is recommended to have been used for a minimum of 12 to 24 months as a rental property before it can qualify for a 1031 exchange. This amount of time should show the IRS that the intent of the property was for productive use.

A similar rule applies to swapping out property to use as a primary home. As of an IRS safe harbor rule implemented in 2008, a property purchased under Section 1031 must meet the following requirements for two years after its purchase:

• The property must be rented to a tenant who is not the buyer for a minimum of 14 days per each 12-month period.
• The buyer cannot use the property for their own personal use for more than 14 days per 12-month period OR 10% of the number of days during which the property is rented to a tenant.

Provided that these rules are followed, primary residences may technically be bought and sold using a 1031 exchange. However, it’s critical to ensure the replacement property follows all 1031 guidelines and tax regulations to avoid nullifying the exchange.

One of the most vital yet commonly misunderstood rules in a 1031 exchange is the like-kind rule. The rule indicates that the relinquished and replacement properties must be “like-kind.” This is often misinterpreted as the properties must be the same. Instead, this rule is very broadly defined and mostly refers to the nature or character of the properties rather than their grade or quality.

Under this rule, various types of real estate may be exchanged for one another. For example, unimproved real estate may be exchanged for improved real estate, as this relates to the quality of the property rather than the character under the 1031 guidelines. Similarly, farmland may be exchanged for a strip mall, industrial property or even rental property, as this also has less to do with the property’s character than the quality and grade.

This rule does prohibit certain types of exchanges that relate to the nature or character of the properties, however. For example, domestic properties may not be exchanged for international property. Additionally, the Tax Cuts and Jobs Act of December 2017 prohibited personal property like franchise licenses, aircraft and artwork from qualifying for 1031 exchanges, meaning only real property can qualify for a 1031 exchange.

The IRS requires that the net market value and equity of the property or properties purchased be equal to or greater than that of the property sold to completely avoid capital gains taxes. On top of the properties’ values, expenses and fees are also included in these totals. Some expenses that can be paid with exchange funds include:

• Commissions and fees for brokers, qualified intermediaries, tax advisers, and attorneys.
• Filing, finder, and escrow fees.
• Title insurance premiums.

Expenses you cannot pay with exchange funds include property taxes, financing fees, maintenance costs, repair costs, and insurance premiums.

If the replacement property’s total value, including the associated expenses, is less than that of the relinquished property, this results in what is called “boot.” The boot is the difference in value between the replacement property’s total cost and the relinquished property’s value.

While the presence of boot will not disqualify a seller for a 1031 exchange, it will require them to pay capital gains taxes on the boot amount. Typically, the qualified intermediary will pay out boot at the end of the exchange, after which point the seller is responsible for paying taxes.

One thing many sellers forget to consider in an exchange is loans. A mortgage is permissible on either side of the exchange and will count alongside the value of the respective property. If the replacement property’s mortgage is less than that of the property being sold, the difference is treated the same as cash boot.

1031 exchanges allow investors to defer the capital gains tax, so they can use the entire proceeds from a sale to purchase larger properties instead of paying a portion of those proceeds toward taxes. By minimizing the loss of purchasing power, investors can grow their wealth more quickly and open up more opportunities for investment.

The deferred taxes owed to the IRS after performing 1031 exchanges are erased upon the seller’s death.

As long as the seller continuously performs 1031 exchanges to purchase larger properties through their lifetime, they can grow their wealth tax-free and pass it on to their heirs, who will inherit the properties without the deferred taxes.

Instead, the heirs receive the property at a stepped-up basis equal to the property’s fair market value at the time of inheritance.

If the heir immediately sells the property at fair market value, they do not need to pay capital gains taxes since the sale price and basis value match.

If the heir sells the property at a later date when it has increased in value, however, they will need to pay capital gains taxes for the difference between the basis value and sale price.

Alternatively, the heir can perform a 1031 exchange and defer any capital gains taxes when they sell the property at a higher rate.

Long-term capital gains have a maximum tax rate of 20%, with depreciation recaptured at 25%. Because a 1031 exchange allows investors to defer their taxes on the new investment property, they can use that extra cash towards a wider range of purchasing options. Depending on the property’s price, taxpayers may have access to thousands or hundreds of thousands of dollars to invest in a larger property or potentially receive a higher loan.

With more funds available immediately after the sale, investors can work with their qualified intermediary to acquire multiple properties in a single exchange to diversify their portfolios. Investors can also consolidate several properties into one to make property management easier, such as exchanging two duplexes for a retail strip center or one property in a more expensive state for three in a more affordable one.

This flexibility makes managing investment risk more efficient, enables investors to adjust properties based on their desired level of involvement and allows them to take advantage of new opportunities across the U.S.

Investors can bring in additional income year after year by investing in more valuable and profitable properties through a 1031 exchange. For instance, investors can use the funds from the sale that won’t be taxed to exchange vacant land for a commercial building that generates a steady income and depreciation benefits.

1031 exchanges must follow every rule and regulation to the letter, otherwise they will be considered failures. Investment property owners need to know and follow the 1031 guidelines, including what types of properties qualify, how many properties can be identified, what the purchasing guidelines are and more.

Any mistakes, such as failing to identify enough properties, identifying too many and failing to meet the 95% rule, or missing crucial deadlines, can result in a failed exchange. For this reason, it is recommended to work with professionals who are highly familiar with 1031 exchanges to avoid falling outside the rules and harming the exchange’s success.

If a seller cannot meet the deadlines for the 45-day identification period or the 180-day exchange period, the 1031 exchange is considered a failure. Therefore, the seller will not be able to defer the capital gains tax from selling their property.

This is especially problematic for those who have large capital gains and/or depreciation recapture taxes owed. Upon this failure, sellers have to pay the capital gains taxes for their recent sale and any sale they have performed in the past that utilized the 1031 exchange rule.

One significant issue that investors may encounter is depreciation. Depreciation is the amount of cost on an investment property that is written off each year due to wear and tear. Capital gains taxes are calculated based on a property’s original purchase price plus improvements and minus depreciation.

If an investor sells a property for more than its depreciated value, they have to recapture that depreciation as part of their taxable income from selling the property. If depreciation is not accounted for in subsequent 1031 exchanges, investors may find that their rental incomes fail to keep up with depreciation expenses.

1031 exchange properties are illiquid. Most real estate investors who own exchange properties used for investment or business purposes, such as renting, should hold their properties for a minimum of two years to prove the intent of use to the IRS and avoid being disqualified from a 1031 exchange for “flipping.”

This illiquidity is particularly reserved for investors part of the Delaware Statutory Trust (DST) which is a legal entity that gives investors a fractional share of the assets or properties as co-owners. 

Investors in a DST cannot make decisions on total property management. In a DST, investors give control to the sponsor for landlord responsibilities and have no say in when the property will go up for sale. Compared to investing directly in a property, investors in a DST have limited transferability and authority over operating decisions.