Looking to complete a like-kind exchange? Learn more about section 1031 of the tax code and how it could save you money on capital gains.
By Derek Doke, CCIM
Section 1031 of the U.S. tax code allows investors to exchange similar properties without paying capital gains tax on the profits of the sale. This rule only applies to investment properties or buildings used in the operation of a business. Like-kind properties—a phrase used to describe 1031 trades—are typically exchanged based on value, rather than type. 1031 exchanges only apply to property in the United States.
Choosing to exchange properties instead of selling and purchasing new assets has a variety of benefits. Not only are there significant tax breaks associated with a 1031 trade, but it can help investors roll their capital into more lucrative investments quickly. 1031 exchange rules and regulations are extensive. Enlisting the help of financial experts is highly recommended.
Eligible 1031 Exchange Properties
Not all properties are eligible for like-kind exchanges, as was the case under the original law. In 2017, the Tax Cuts and Jobs Act disallowed the exchange of personal or intangible property, such as “machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and intangible business assets.”
In general, you may trade only real property used solely for investment or business purposes under the new law. Mutual ditches, reservoirs, and irrigation docks are also eligible for 1031 exchanges. However, corporate stock or partnership interest is not, and never was, eligible for exchange. The following real estate items qualify for like-kind exchanges:
- Office buildings
- Apartment buildings
- Raw land
- Retail shopping centers
- Single-family rentals
- Duplex or triplex
- Industrial buildings
The size and style of the building do not need to be the same for the trade to be legal. For example, investors may exchange a single-family rental property for a large apartment building. Although these two properties are not similar in style, their values are what determine the trade.
Investors must roll all of their capital into the new property to benefit from the tax break. If the single-family rental is worth $1,000,000 and an investor exchanges it for an apartment building worth $2,000,000, he or she would defer paying capital gains tax on the $1,000,000 earned from the sale of the rental house.
How to Avoid ‘Boot’
If the new property is worth less than the first, investors may face paying for “boot.”
Boot is ineligible property resulting from an exchange. For example, if an investor sells the single-family rental for $1,000,000, earning $200,000 in profit, but trades it for a property worth $900,000, the investor will incur capital gains tax on the $100,000 not rolled into the new property. Although it is not mandatory to avoid boot, paying tax on any income gained from a sale may outweigh the benefits of the tax breaks associated with a 1031 exchange.
Identifying a Replacement Property
Investors must submit in writing an unambiguous description of the replacement property for it to be considered in the exchange. Identifications typically include a building address or a detailed, legal description of the property.
Types of 1031 Exchanges
There are three main types of property exchanges subject to section 1031 of the tax code. The conditions of the sale, the length of the exchange, and when you acquire the property indicates the nature of the trade. A qualified intermediary often approves and oversees the trade, holding properties until the deal closes.
- Delayed Exchange – Investors may complete the process within 180 days, thus the name delayed exchange. After one property is sold, a replacement property is identified within 45 days and closed within 180 days to qualify for the tax break.
- Built-to-Suit Exchanges – New builds or properties that require renovation can be used as replacement properties within the same 180-day window. However, if any construction work extends beyond 180 days, the value of those assets cannot be included in the exchange. Therefore, built-to-suit exchanges make sense when an investor knows the work will be completed in time. Failure to do so may result in paying capital gains tax on profits, defeating the purpose of a like-kind exchange.
- Reverse Exchange – If an investor purchases a replacement property before securing the sale of the first, it is called a reverse exchange. A qualified intermediary must approve and hold the property until the original unit is sold. The same 180-day timeline requirement applies.
1031 Exchange Rules
Since the beginning of the 20th century, updates to section 1031 of the tax code have shaped how investors can benefit from the law. The following rules impact both buyers and sellers conducting 1031 exchanges.
- The 180-day rule applies to a variety of tax breaks available to investors, including a 1031 exchange. Property owners must complete the trade within 180 days of selling the first property to qualify for the tax break. In addition, the replacement property must be chosen within 45 days of selling the original property to be eligible for exchange.
- The depreciation rule requires investors to recapture any depreciation of their original property in the replacement unit. This is only necessary if the depreciated amount exceeds the value of the first property. In some cases, profits may incur income taxes, potentially outweighing the benefits of performing a 1031 exchange.
- The three-property rule allows investors to identify three potential replacement properties regardless of their value. As with all exchanges, the investor has 45 days to complete the selection process and 180 days to acquire one of the three options.
- The 200% rule allows investors to identify an unlimited number of properties within 45 days. However, the cumulative value of all potential properties must not exceed 200% of the value of the sold property.
- The 95% rule allows investors to identify unlimited replacement properties. However, he or she must acquire 95% of the total value of those chosen properties. Investors rarely use this rule as it would require them to purchase almost all the chosen properties to qualify for the trade.
The law states that investors must complete a 1031 exchange using property that is ‘substantially the same’ as the item he or she identified at the 45-day mark. The property cannot differ in nature or character from what was originally selected. This delicate process makes it important to work with 1031 exchange experts or financial advisors when completing a deal.
Read more from our blog: