IRC Section 1031, also known as a 1031 exchange or a “like-kind” exchange, allows investors to defer tax on gains from the sale of an investment property if they reinvest the proceeds into a similar (like-kind) property. It was enacted by congress in 1921 to promote economic growth by encouraging reinvestment into the economy and to avoid harming investors through unfair taxation as they reinvest.
Although many associate this rule as a tactic used in commercial real estate, there are many other types of investments to which the rule can apply including: livestock, oil, gas, and mineral interests, gold, silver, and numismatic coins, water and ditch rights, and collectables such as antiques, cars, stamps, and gems. Those things not eligible include a primary residence, indebtedness, stocks, bonds, or notes, partnership interests, and inventory.
Five Important General Rules:
- Use of Intermediary
The simplest form of exchange is when a buyer and seller swap properties simultaneously between each other. However, the vast majority of 1031 exchanges are known as delayed, three party, or Starker exchanges. In this type of exchange, an intermediary is needed to hold the cash from the sale of the first property until the investor identifies the new property and then the cash is used to close on the replacement.
- Same Taxpayer
The tax return and name appearing on the title of the property that is sold must be the tax return and titleholder that purchases the replacement property. For example, if the first property is owned by the entity “ABC Partnership,” which is comprised of six total equity partners, then the titleholder for the replacement property must also be “ABC Partnership” comprised of the same six equity partners.
Although we typically associate 1031 exchanges with commercial real estate, there are many other types of investments that can qualify. The “like-kind” terminology simply refers to swapping one type of investment with another (i.e. real estate with real estate or antique with antique). Fortunately for real estate investors, real estate covers a broad spectrum of assets so for instance, an investor could sell an apartment building and trade into a retail center, office building, another apartment project, or even land.
There are two time constraints to take into consideration when consummating a 1031 exchange. The first is that the investor has 45 days from the time the sale of their property closes to identify a new property to purchase. The second is that the investor must complete the purchase of their new asset no later than 180 following the close of their original asset. Please note that the total time frame to complete the 1031 exchange is 180 days, and not 45 days plus 180 days.
- Property Identification
Within the first 45 days following the sale of the relinquished property, the investor can identify up to three replacement properties, regardless of value. These properties must be identified in writing by either a property address, legal description, or distinguishable name of the project. The investor must close on one of the three identified properties to qualify for the exchange.
Exchanger Beware! Three Points to Consider
There are few points to be aware of before entering into a 1031 exchange.
- Although taking advantage of this tax strategy can create savings for the investor, they must be careful not to overpay for the replacement property, especially in a tight market. Resulting future losses from overpaying could offset any current savings on taxes.
- In order to avoid paying taxes on the proceeds from a sale, the investor must make sure they are trading up: purchasing a replacement property that is at a higher value or cost basis than the relinquished property. Any leftover cash, or “boot,” from the sale will be taxed, typically as a capital gain.
- Make sure to use a qualified intermediary. There have been instances of exchange facilitators filing bankruptcy or being unable to meet their contractual obligations to their client. This can result in the investor not being able to meet the strict timelines set forth by the tax code, thereby disqualifying them from completing the 1031 exchange.
1031 Exchanges Explained
Written by Adam S. Finkel, CCIM