An Introduction to 1031 Exchanges

The 1031 exchange is a powerful mechanism for real estate investors: enabling both individuals and businesses to sell existing assets and use the proceeds to purchase new assets while deferring taxes on their profits. It’s a popular strategy, and with good reason. Deferring capital gains tax frees up additional capital that investors can use to acquire new assets, enabling them to grow their portfolios in a tax-efficient manner.

However, 1031 exchanges are complex, and it’s always advisable to seek support from experienced tax advisors, attorneys, and other intermediaries. This guide serves as an introduction to 1031 exchanges, covering the key definitions, rules, and use cases that real estate investors should consider. 

What Are 1031 Exchanges?

Section 1031 of the United States Internal Revenue Code permits businesses and individuals to defer federal taxes on qualified exchanges of real estate. 

1031 exchanges, as these exchanges are commonly known, are only applicable to real property that is held for investment, used in a trade or business, or held for production of income. This could be residential property (though not a primary residence), commercial property, or vacant investment land held for long term appreciation.

A 1031 exchange enables investors in these properties to defer taxes on gains realized through the sale of these assets, provided these gains are reinvested into the acquisition of a qualified new property or properties within a certain timeframe. 

Who Are The Key Parties in a 1031 Exchange?

A 1031 exchange involves at least two properties, and sometimes more. The property that the investor is selling is referred to as the relinquished property. The new property, or properties, that will be acquired are known as the replacement property or properties. 

Each individual transaction has a buyer and a seller. If you are executing a 1031 exchange, you will be both the seller of the relinquished property and the buyer of the replacement property. 

Perhaps the most important party is the intermediary. To execute a 1031 exchange, the proceeds of the relinquished property are typically put in a qualified escrow, usually with an intermediary, typically a banker, attorney or 1031 exchange advisor, immediately upon sale. The individual investor must not hold the cash proceeds from the sale of the relinquished property. Doing so triggers capital gains. Having reliable legal and tax advice is vital in successfully conducting a 1031 exchange.

When Does It Make Sense to Do a 1031 Exchange?

A 1031 exchange will often make clear financial sense, but the choice of whether to pursue a 1031 exchange does require nuance.  

First, the investor must have realized a significant gain on the sale of the relinquished property. There are considerable costs associated with a 1031 exchange, including consulting fees, transaction costs, and more. The gain realized must be large enough that the tax deferral outweighs the cost of the exchange. 

Here are a couple of examples to illustrate this concept. 

If an investor realized a gain of $100,000, they stand to defer approximately $20,000 in long-term capital gains tax. However, to achieve this deferral, they would have to spend thousands of dollars in fees and quickly close on a new property. In this scenario, it’s unlikely the tax savings would be worth the cost of a 1031 exchange. 

However, if an investor realized a $1,000,000 gain, they stand to defer around $200,000 in taxes: much more significant savings. In this instance, where the tax savings are a multiple of the costs involved, a 1031 exchange makes much more sense. 

1031 exchanges are also a powerful tool in estate planning. The property is passed down to the beneficiaries of the estate at fair market rate and the deferred tax the investor owed is eliminated under current basis step up rules.  

However, there are also situations where it may not make sense to execute a 1031 exchange. Many real estate investors have losses from other sources that offset their gains: perhaps through accelerated depreciation on newer assets. Another example: real estate funds that periodically liquidate assets to return capital to investors. 

Deciding whether a 1031 exchange makes sense is very situational, and is not a choice investors should make without first consulting real estate tax professionals. 

Key 1031 Exchange Concepts 

There are several fundamental 1031 exchange concepts that investors should bear in mind. Once the sale of the relinquished property closes and the intermediary receives the funds, there is a limited period of time to complete the exchange. It’s also important to have clarity on the types of replacement properties you may purchase. Here is a little more detail:

45 Day Rule

Within 45 days of the sale of the relinquished property, you must designate the replacement property in writing to the intermediary. Investors can nominate multiple properties according to replacement property rules.

180 Day Rule

Within 180 days of the sale of the relinquished property, you must close on the replacement property. 

Replacement Property Conditions

The replacement property or properties that investors designate must satisfy one of the following conditions:

1. Three Property Rule: investors may identify three properties within 45 days, and can close on any combination of these, provided all proceeds from the sale of the relinquished property proceeds are reinvested. 

2. 200% Rule: investors may identify any number of properties provided the cumulative value of these properties does not exceed 200% of the value of the relinquished property. Investors are not required to close on all of these properties. 

3. 95% Rule: investors may identify any number of properties and exceed 200% of the value of the relinquished properties, but must close on 95% of the value of assets identified. 

Avoiding Common 1031 Exchange Errors

A 1031 exchange is a complex mechanism and errors could expose investors to tens of thousands of dollars in capital gains tax they had planned to defer. As such, it’s crucial for real estate investors to avoid errors commonly made in the process. 

One common trap is focusing on net cash: the bottom line on the settlement statement. This is an error as this figure often includes disbursements such as loan payoffs and expense pro-rations. However, the key to a successful 1031 exchange lies in reinvesting only net proceeds from the relinquished property into a qualified replacement property. 

Calculate net proceeds using this formula:

Sales Price on Contract – Expenses of Sale (i.e. brokerage fees) = Net Proceeds of Sale

Provided the net value of the qualified replacement property (contract price plus acquisition costs) exceeds the net proceeds of the sale of the relinquished property, investors have a solid basis for a tax deferral. 

However, even when this is the case, it’s still possible to have tax triggers. If an investor transfers other appreciated property to purchase the replacement property, it’s possible to run into issues. If the appreciated property used in an exchange is not like-kind property, the IRS will interpret this as the investor converting a non-cash item into cash. The net sales proceeds will be considered as having been used as cash to accommodate that transaction, limiting the probability of success of a 1031 exchange.

Get Support from Experienced Real Estate CPAs

1031 exchanges offer significant tax benefits, enabling real estate investors to defer taxes and reinvest into new assets. 

While the concept may seem simple, it’s crucial to meticulously execute a 1031 exchange. Mistakes can often void the exchange, potentially costing investors hundreds of thousands of dollars. With such high stakes, it’s important to partner with an experienced real estate accounting firm with a track record of successful 1031 exchanges. 

At Smith and Howard, our team of real estate accountants works with individual and commercial investors throughout the U.S. To learn more about 1031 exchanges, contact an advisor today.