Nobody enjoys paying taxes. Well, maybe some do, but I sure haven’t encountered them. For the majority of people who like to avoid taxes, a 1031 Exchange allows owners of investment real estate to exchange property and defer payment of capital gains tax, but there are some very important requirements and deadlines under Section 1031 of the Internal Revenue Code (“IRC”) that a taxpayer must comply with in order for a 1031 Exchange to be recognized by the IRS.
What is a 1031 Exchange?
Simply put, a 1031 Exchange is the exchange of one property for another like-kind property for the purpose of deferring payment of capital gains tax. Upon successful completion of a 1031 Exchange, a taxpayer is able to transfer the low basis from the property they are selling (the “Relinquished Property”) to the property they are acquiring (the “Replacement Property”), which defers payment of tax on any recognized capital gain until the Replacement Property is sold.
In the most basic 1031 Exchange, a taxpayer would simultaneously swap one like-kind property for another, deed for deed, with no exchange of cash. Simultaneous swaps are rarely the case and most taxpayers utilize a deferred like-kind exchange. In a deferred exchange, a taxpayer assigns its contractual rights to sell a Relinquished Property and obtain a Replacement Property to a non-related third party to complete the transaction.
Before deciding to embark on a deferred 1031 Exchange, a taxpayer must determine if the proposed like-kind exchange qualifies as a 1031 Exchange under the IRC.
To qualify for deferral of gain under a 1031 Exchange, the Relinquished Property and the Replacement Property must be both “qualifying property” and “like-kind property:”
Qualifying property is real property held for investment or for productive use in a trade or business and not held primarily for sale. Examples of qualifying property include commercial buildings, vacant land, and rental property. A taxpayer’s primary residence, real property used for personal purposes, or real property held primarily for sale (property flipping) is not “qualifying property.”
The properties involved in the exchange must be of “like-kind,” which simply means that the Relinquished Property and the Replacement Property must be of the same nature or character, even if the properties differ in grade or quality, so long as real property is exchanged for real property. For example, a farm property could be exchanged for a condominium or an apartment complex could be exchanged for vacant land. Once again, however, a taxpayer cannot use their primary residence in a 1031 exchange, so a primary residence is not considered a qualifying property or a like-kind property.
Same Party Required
The taxpayer on the front end of a 1031 Exchange must be the same taxpayer on the back end. For example, if Joe wants to sell his vacant wooded tract and wants to buy a commercial building, his multi owner company, ABC, LLC, cannot be the taxpayer who purchases the commercial building. Instead, Joe needs to be both the seller of the Relinquished Property (vacant wooded tract) and the buyer of the Replacement Property (commercial building).
Because any money received by a taxpayer from a sale of Relinquished Property is subject to recognition of taxable gain, all proceeds intended to be exchanged for like-kind property must be held and applied by a qualified intermediary or “QI.” A QI is an independent third party that assists in facilitating a 1031 Exchange.
A taxpayer must enter into an Exchange Agreement with a QI prior to closing the sale of the Relinquished Property. The Exchange Agreement clarifies that the QI will obtain the rights of the taxpayer to sell the Relinquished Property, receive the funds from the sale, and apply them to the Purchase of the Replacement Property. The Exchange Agreement must expressly limit the taxpayer’s right to receive, pledge, borrow, or otherwise obtain money or property held by the QI until the 1031 Exchange is completed. Using an experienced QI ensures that all documentation required by the IRC is properly executed and that all funds remain secured.
A taxpayer has 45 days after closing the sale of the Relinquished Property to “identify” Replacement Property that the taxpayer intends to acquire in the 1031 Exchange.
Proper identification of a Replacement Property must be in writing and signed by the taxpayer, must clearly describe the Replacement Property and must be delivered to the QI within the 45-day identification period.
Completion of Exchange
A 1031 Exchange is completed when the purchase of the Replacement Property is closed. The Replacement Property closing must take place within 180 days after the closing of the Relinquished Property and not 180 days after the 45-day identification period. If the Replacement Property is not closed within 180 days, the QI will disburse the proceeds of the Relinquished Property sale, which will be recognized as a capital gain and subject to capital gains tax. While I would like to tell you that a 1031 Exchange is a simple series of transactions (they are not) and everybody should consider one (they should not), the truth is every proposed 1031 Exchange has different facts and circumstances and this article just scratches the surface of the requirements of the IRS. Stay tuned for future articles that take a deeper dive into some of the issues a taxpayer may encounter when considering a 1031 Exchange. If you are considering a 1031 Exchange, contact your legal counsel or tax advisor in advance to avoid any pitfalls and ensure that your 1031 Exchange is properly structured to maximize all the tax advantages that come with a 1031 Exchange.