1031 Exchanges: The What, Why, When, & How

Real estate investors trying to defer taxes may want to explore like-kind exchanges.

What exactly is a 1031 exchange?

For some real estate investors, it may be a nice answer to a dilemma involving an income property. A properly executed 1031 exchange lets an investor sell one property and buy a similar one while deferring capital gains taxes. Also called a Starker exchange or a like-kind exchange, this procedure has been used for some time.1

Why would an income property owner choose a 1031 exchange over a standard sale?

It comes down to taxes. The Internal Revenue Service does not consider a Starker exchange to be a taxable sale. It also comes down to timing. A great investment property may suddenly appear on the market and acquiring it through a Starker exchange may make more sense, financially. Or, maybe the investor wants more cash flow off his or her real estate portfolio while “on the hunt” for new properties.1,2

When would an investor be likely to explore a 1031 exchange?

Financial factors and life factors may provide the motivation. While investors cannot escape capital gains taxes forever, some prefer to “swap until they drop”: why should they pay capital gains tax while selling an investment property today, if they can defer that tax while acquiring another property? Many real estate investors reach a point where they have had enough of property management issues. At that point, exchanging out of their property to a property with third-party management seems very appealing. Additionally, since a 1031 exchange defers capital gains tax, it frees up more money for property acquisitions – money that would otherwise go to the tax collector.2

How does a 1031 exchange work?

It unfolds in three steps.

  1. First, an investor approaches a qualified intermediary (QI) and notifies the QI that he or she wants to exchange out of a property that has appreciated in value, ideally with a replacement property identified.
  2. Next, the property is sold and the proceeds are placed in escrow.
  3. Finally, the investor directs the QI to buy a replacement property with those sale proceeds within a specified window of time.1

A little more explanation is necessary. The QI is a necessity; a 1031 exchange cannot occur without one. An investor can easily find a QI through an escrow officer. (A QI cannot be an attorney, broker, real estate agent, or CPA that the investor has worked with within the past two years or an investor’s parent, child, or sibling.) The intermediary buys the replacement property in its name, not the name of the investor; afterward, it transfers the title by deed.3

The definition of “like-kind” is broad and a wide range of investment properties may meet it. With the help of a QI, an investor may swap acreage for a light industrial building, exchange a shopping center for an apartment building, or swap a motel for an RV park. Swaps of the exact same type of property are routine. Investors are also allowed to exchange out of multiple properties into a single property (and vice versa). Properties located in different states may be swapped as well.1,4

The key is to identify the replacement property within 45 days of the sale of the first property. That must be done. Another must: the replacement property must be bought within 180 days of the sale of the relinquished property or the due date of the investor’s federal tax return (with extensions), whichever date occurs first. If these deadlines are not met, the 1031 exchange falls apart.1

The investor must not control (or appear to the I.R.S. to control) the sale proceeds from a relinquished property in a 1031 exchange. The I.R.S. may interpret that as the investor profiting from the sale and taxation may result.4

Lastly, remember these three details. One, parties exchanging qualifying properties in a 1031 exchange cannot be spouses, siblings, or parents and children. Two, if a Starker exchange does involve related parties, neither the seller or buyer can unload an involved property within two years of the date of the exchange; if that happens, the exchange is invalid and the investor must report the capital gain (or capital loss) as of the date of the transaction. Three, the Tax Cuts and Jobs Act restricted like-kind exchanges to real property. Prior to 2018, investors could use 1031 exchanges to swap either real or personal property.1,5

If you are thinking about selling income property, consider a 1031 exchange. Contact a qualified intermediary to explore the possibilities. Proceed carefully, and abide by the legal and tax advice provided to you.

 


Citations.

1 – money.usnews.com/investing/real-estate-investments/articles/2017-12-18/why-1031-exchange-investments-are-worth-a-look [12/18/17]

2 – 1031exchange.com/1031-exchange-questions-consider-1031/ [1/11/18]

3 – thebalance.com/how-a-qualified-intermediary-faciliates-a-1031-exchange-1798718 [3/29/18]

4 – westwoodnetlease.com/1031-exchange-5-reasons-shouldnt-ignore-tax-tool/ [1/4/18]

5 – agriculture.com/farm-management/finances-accounting/9-key-tax-law-changes-that-will-impact-producers [4/4/18]

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.