Understanding the 1031 Exchange
If you’re selling an investment property, you can defer taxes with a 1031 Exchange, also known as a Like-Kind Exchange. While it can be a bit complicated, the potential savings may be worth the effort if your situation qualifies.
What is a 1031 Exchange?
The 1031 Exchange, or Like-Kind Exchanges, are named after the Internal Revenue Code they fall under. Essentially, it allows a property owner to defer or avoid paying taxes on real estate proceeds by exchanging business or investment property for a like-kind property.
If an investor owns property they use for business or investment purposes, by engaging in a 1031 exchange, they are allowed to swap their existing asset for new real estate. Under the condition that they continue to use the new property for “like-kind” business and investment purposes, the investor—aka, Exchanger—can defer the taxes that would otherwise be due upon the sale until they cash out by selling the exchanged property. Vacant farmland, for example, can be replaced with industrial property. Small apartment buildings can be replaced with vacation-rental homes or single-family rentals.
The replacement property must be of equal or greater value. When the prior asset is sold, all proceeds from the sale must be reinvested in its replacement. Additionally, any debt on the sold property must be replaced with an equal or greater amount on the newly exchanged property.
It’s this strategy that a retiree from Miami used to parlay a $2.5 million investment into $25 million, according to a recent Wall Street Journal article:
…Savvy investors are conducting deals and deferring taxes, in some cases for decades. Louis Appignani, 88, a retired entrepreneur from Miami, purchased his first office building in 1993 for $2.5 million. He sold it in 2015 for $14.5 million, a $12 million gain, but he paid no taxes because he acquired an 80-acre working ranch in Jackson Hole, Wyo. for $14.5 million in a 1031 Exchange. Mr. Appignani planned to hold on to that land, but he received an unsolicited offer for it in 2020 and ultimately sold the land for $25 million. He used that money in another 1031 Exchange to purchase five parcels of land in Asheville, N.C.
While the process he went through was complex, the benefit was worth the effort.
Order of Operations
For a 1031 Exchange to be valid, and therefore provide the investor with the tax deferred benefits, important steps must be taken in a certain order within a strict time period.
Step One: Identify a Qualified Intermediary
Before the exchange can begin, the investor is required to solicit the services of an independent third-party qualified intermediary. That person assists with the following:
- Prepares any required documentation
- Securely holds your exchange funds
- Escrows the sale proceeds during the exchange
- Disburses the funds to purchase the replacement property
- Returns unused (taxable) funds to the investor
Step Two: Identification Period
Within 45 days following the sale of the property the investor wishes to replace, the investor is required to identify the new property they wish to replace it with. Unless the investor qualifies for a disaster extension, the 45-day requirement is fixed and cannot be adjusted. This is one of the most difficult steps within the 1031 Exchange process.
A replacement property is considered identified if the investor purchases it within the 45-day period, or they submit a signed, written notice of identification to the qualified intermediary or another non-disqualified person—the seller of the replacement property or the settlement agent. There are strict guidelines regarding what investors must include in notices to be considered valid. However, investors are given flexibility in which of the two rules they use for their identification:
- Three Property Rule: Investors are allowed to identify up to three potential replacement properties, without regard to their fair market value.
- 200% Rule: As long as the aggregate value doesn’t exceed 200% of the value of the sold real estate assets, investors are allowed to identify any number of replacement properties.
Step Three: Exchange Period
The investor has up to 180 days to acquire or close on a replacement property for the asset sold. This countdown starts on the day the investor sells the property and runs in parallel to the 45-day identification period. Like the Identification Period deadline, the 180 days is a non-negotiable period unless the investor qualifies for a disaster extension.
Once a new property has been purchased through the 1031 Exchange process, the investor will have successfully deferred payment of capital gains and tax on depreciation recapture.
How to use 1031 Exchanges as an Estate Planning Tool
Taxpayers and their heirs can benefit from this strategy. Under the current tax code, taxpayers who complete successive 1031 exchanges without paying capital-gains taxes who then die may avoid taxes altogether. The taxpayer’s heirs inherit the replacement property with stepped-up basis equal to the value of the property at the time of death. That means the property’s value is reset to the market price at the time of the taxpayer’s death. In this situation, the tax deferral becomes permanent tax forgiveness, and that makes 1031 exchanges a great estate-planning tool.