As a commercial mortgage broker, my job is not only about arranging financing for my clients’ deals. I also take great pride in helping my clients understand the various tools for maximizing the value of their investments. One of those tools is the 1031 exchange, an often-overlooked way of deferring capital gains tax and in turn, growing your real estate portfolio.
In today’s article, we take a deep dive into 1031 exchanges – including the types of 1031 exchanges and common 1031 exchange pitfalls for investors to avoid. This guide is intended for real estate investors as well as commercial real estate agents, attorneys and other mortgage brokers looking to help their clients better understand how 1031 exchanges work.
Read on to learn more.
What is a 1031 Exchange?
One of the primary reasons people invest in commercial real estate is because it is a highly tax-advantaged industry. There are several reasons why this is the case, one being the tax savings associated with doing a 1031 exchange.
In theory, the 1031 concept itself is simple: Reinvest the proceeds from the sale of business or investment property into a like-kind investment in order to defer paying capital gains tax.
Doing so increases an investor’s purchasing power because he can use 100% of his current property equity to invest in a replacement property. Using a 1031 exchange is a great tool for investors looking to grow their real estate portfolios.
In reality, 1031 exchanges are quite complex. Section 1031 of the Internal Revenue Code (from which the term gets its name) contains many nuances that can be daunting to those unfamiliar with how these exchanges work.
Types of 1031 Exchanges
Most real estate investors are familiar with a “delayed exchange,” the most common form of 1031 exchange. Yet there are actually five different forms of 1031 exchanges, and each can be used for different purposes.
Simultaneous Exchange
The Simultaneous Exchange was the original 1031 exchange, and allows investors to swap properties directly, relinquishing and closing on their replacement property within the same day – hence the name “Simultaneous Exchange”. With this type of exchange, two parties literally exchange the deeds and other necessary documents to trade assets, simultaneously transferring ownership to one another. No monetary compensation is allowed.
This is the oldest type of 1031 exchange, though it is rarely used today given the operational complexities. Most investors have a difficult time finding an investment property that they want to buy, a property that happens to be owned by someone who ALSO has an interest in trading for their investment property. On the off chance an investor engages in a Simultaneous Exchange, he may use a qualified intermediary (see below) to handle the transaction, though the IRS does not require him to do so.
Delayed Exchange
The Delayed Exchange is the most common type of 1031 exchange. A Delayed Exchange is one in which a third party, known as a “Qualified Intermediary” (QI), facilitates the selling of one’s property and assures that proceeds are used for the acquisition of another like-kind property. Upon the QI’s receipt of money from the sale of a property, an investor has 45 days to formally identify which replacement property (or properties) he wants to buy.
In order for a replacement property to be considered valid under the rules of the Delayed Exchange, it must meet one of the three following criteria:
- The Three Property Rule: The investor has identified up to three different properties as potential purchases within the 45-day identification period, regardless of the total fair market value of the properties.
- The 200% Rule: The investor has identified an unlimited number of replacement properties, but the total fair market value of all properties does not exceed 200% of the value of the property being relinquished through this 1031 exchange.
- The 95% Rule: The investor has identified an unlimited number of exchange properties, but he receives at least 95% of the value of all identified replacement properties before the end of the exchange period.
The “exchange period” is an important deadline investors must monitor while doing a 1031 exchange. An investor only has 180 days from the date he closes on the relinquished property to close on the replacement property, otherwise known as the exchange period. The transaction must be settled within 180 days for the Delayed Exchange to be considered successful. These 1031 rules are critically important for investors to follow.
Expect to pay between $750 and $1,250 to hire a qualified intermediary when doing a Delayed 1031 Exchange.
Improvement Exchange
An Improvement Exchange allows an investor to make improvements on a new replacement property using his tax-deferred equity prior to closing on the replacement property. This type of exchange is also referred to as a “construction” or “built-to-suit” exchange. It is particularly useful for investors who are interested in acquiring a property that is not of equal or greater value than the property they intend to relinquish; for investors willing to take on the ground-up construction of their new replacement property; or for investors who have identified a property of equal or greater value that is in need of significant improvements. Improvement Exchanges are complicated, but often result in an exchanger finding a better investment than he could otherwise find on the open market.
Improvement Exchanges have a few basic requirements. First, all exchange equity must be spent on improvements by the end of the 180-day exchange period (even if construction is not complete). Second, the exchanger must receive substantially the same property he identified during the 45-day identification period. And finally, the replacement property must be of equal or greater value than the relinquished property at the time of transfer to the exchanger.
Personal Property Exchange
The Personal Property Exchange involves the sale of a personal asset to invest in another like-kind asset. It may be a tangible asset (e.g. vehicles, artwork, office furniture) or intangible (e.g. business licenses, copyrights, website URL). Investors are urged to review the North American Standard Industrial Classification manual to determine whether a specific form of personal property qualifies for this type of 1031 exchange. These exchanges must also adhere to the strict 180-day exchange period.
Personal Property Exchanges are often used in conjunction with other forms of 1031 exchanges in order to sell personal and real property at the same time. This is common when a 1031 exchange includes the sale of hotels, restaurants and gas stations wherein the exchanger owns both the building/land and the personal property contained therein.
Reverse Exchange
All of the aforementioned types of 1031 exchanges are considered “forward” exchanges. The outlier is the Reverse 1031 Exchange, which is used when an investor acquires a replacement property before conveying the relinquished property to the new buyer. These are the most complicated forms of 1031 exchanges, and most would argue the riskiest. This is because an investor is still obligated to find and close on a replacement property within the 45- and 180-day timelines. Some investors will struggle to complete the process within 180 days if another property has not yet been identified. There are other strict guidelines associated with the Reverse Exchange. For instance, an investor can never own the two properties simultaneously, which requires the investor to “park” legal title to one of those properties with a QI until the transaction is complete.
That said, a Reverse Exchange can be incredibly useful for an investor who need to act quickly. An investor may need to act on an opportunity before he has had time to even consider listing or selling the property he intends to relinquish. Alternatively, the sale of the relinquished property may fall through and an investor may still want to move forward with the property he intended to purchase using a forward 1031 exchange.
Expect to pay anywhere from $3,500 to $7,500 to hire a qualified intermediary when engaging in a 1031 Reverse Exchange.
Defining a “Like-Kind” Investment
The IRS considers “like-kind” property as any property used in a trade or business as an investment. It generally refers to real estate: single-family, multifamily, commercial, retail, industrial, condos, hotels and raw land are all examples. It also refers to personal property used for business purposes, such as vehicles, airplanes, office furniture, business equipment and even livestock. Personal property can be traded directly through the Personal Property Exchange, though personal property is most often traded in conjunction with some form of real estate.
The term “like-kind” can be somewhat misleading. An investor who sells an apartment building is not required to purchase another apartment building. He can exchange that apartment building for raw land or a strip mall, if he so chooses—as long as that type of property is eligible for exchange.
Stocks, bonds, securities, certificates of trust, interests in partnerships and business inventory intended for sale are examples of property that cannot be sold using 1031 exchanges.
Adding “Boot” to a Deal
There are some situations in which a 1031 exchange includes the transfer of property that is not considered like-kind. For example, the sale might include a cash payment to be used toward capital improvements at the replacement property. This is called “boot”. Because the cash is not considered like-kind property, an investor may be responsible for paying taxes on the boot portion of the exchange.
An investor might also use boot to reduce the mortgage liability on the replacement property below the mortgage liability on his relinquished property. This is known as “mortgage boot.”
Reinvestment Requirement
In order for an investor to defer all of the capital gains on his relinquished property, he must purchase a property of equal or greater value. He must also reinvest ALL cash proceeds from the sale into the new property.
Contrary to popular belief, an investor does NOT have to place debt on the replacement property equal or greater to the debt that was paid off on the relinquished property (though he may). An investor can always add debt or place more cash into the purchase of a like-kind replacement property as long as proceeds from the sale have been invested in their entirety.
As a general rule of thumb, always remember: “trade up” and “no cash out”.
When NOT to Use a 1031 Exchange
Although we’ve touted the benefits of using a 1031 exchange, there are some circumstances in which it might not be appropriate. For example, investors generally do not want to use a 1031 exchange when they have experienced a loss on the property. Instead, they will want to recognize those losses for income tax purposes. Just as capital gains are deferred using the 1031 exchange, so are losses. Deferring losses that would otherwise offset large profits could outweigh the benefits of using a 1031 exchange.
1031 Exchange Pitfalls to Avoid
Any investor considering using a 1031 exchange to defer paying capital gains tax should familiarize themselves with the most common pitfalls. The IRS 1031 exchange rules are complicated, and even the slightest mistake can dismantle a successful transaction.
- Trying to use a 1031 exchange to defer paying capital gains on your primary residence. The same holds true for property held as a second home (e.g., a vacation or summer home). This tool can only be used for investment properties.
What if you used to live in the primary residence but now use it as an investment property? If you have lived in the property for two out of the last five years, then you do not pay capital gains tax (up to $250,000 or $500,000 for a married couple). In this case, you cannot engage in a 1031 exchange. However, if you lived in the home for less than two of the past five years, it is no longer considered a primary residence and you may sell using a 1031 exchange. Any capital gains on the period the property was used as a rental becomes the basis for the 1031 exchange.
- Missing deadlines. This is self-explanatory. The IRS has very clear 1031 rules around the 45- and 180-day timelines. Do not mistakenly assume that the IRS will grant you an extension for time. It won’t. Unless you have a really good reason. The IRS only grants extensions for three reasons: presidentially declared disasters, terroristic actions, and military actions or exchangors serving in combat zones.
- Overpaying for a replacement property. Some people, in their rush to identify a replacement property within the allowable timeframe, end up overpaying for a replacement property – which negates a portion of the cost savings being realized by using the 1031 exchange. Do not advertise to sellers that you are using a 1031 exchange; this may encourage sellers to negotiate a higher price because they know you are on a tight deadline to close the deal.
- Failing to include language in your sales contract about the 1031 exchange. The IRS does not mandate exchangors include language in the contract for the sale of the relinquished property, but it is in an investor’s best interest to gain the cooperation of the buyer while going through the process. Include language in the contract that asks the buyer to cooperate with the exchange.
- Hiring the wrong qualified intermediary. Not all intermediaries are equal. You want someone who is sophisticated enough to really understand the ins and outs of how to successfully complete a 1031 exchange. They should be a valued part of your team. Some QIs are more like paper pushers who send documents along to closing; whenever you have a question, they will suggest you consult with your tax advisor. This isn’t to say that your QI should replace your tax advisor. In fact, IRS rules prohibit QIs from giving you financial advice or acting as you real estate broker. They must be a truly, independent third party. However, your QI should be able to step in and answer basic questions as they arise in order to help guide you through the process smoothly.
- Not evaluating how various types of 1031 exchanges can help you. Most people defer to using a traditional delayed exchange. The majority of investors are not even aware of the other types of 1031 exchanges. Depending on your individual circumstances, the reverse or construction exchange – or some combination of exchanges – might be a better option.
- Trying to access exchange proceeds before the transaction is complete. Exchange proceeds are required to be held in a separate escrow account and can only be accessed by the qualified intermediary until the 1031 exchange is complete. If no replacement properties are identified within the 45-day period, the exchange is considered over and the sale proceeds will be wired to your bank account. Otherwise, exchange proceeds are held until the end of the 180-day exchange period unless they are used to acquire a replacement property before then. Any attempts to hold or otherwise access the exchange proceeds yourself will deem the transaction null and void.
Conclusion
There are obviously several benefits to utilizing a 1031 exchange: you can defer paying capital gains tax, you can increase purchasing power when investing in another like-kind investment, and you can begin to scale your real estate portfolio. Savvy real estate investors use 1031 exchanges all the time.
But 1031 exchanges are also quite complicated. It is always best to have your CPA and/or real estate attorney guide you through this process. This will ensure you are meeting all 1031 obligations and fulfilling all 1031 rules according to IRS guidelines.
Are you interested in using a 1031 exchange to grow your real estate portfolio? Contact us today. We can discuss how 1031 exchanges, when used alongside other attractive real estate financing tools, can be used together to maximize the value of your investments.
