1031 Exchange Benefits
The sale of real estate can result in a significant capital gains tax that can materially eat into the profit from the sale. Investing in replacement real estate on an after tax basis is the reason that 1031 Exchanges have become very popular tax deferral strategies. Federal capital gain tax, depreciation recapture related taxes and state taxes are all compelling factors in favor of 1031 Exchanges.
The 1031 Exchange allows for both the indefinite deferral of the payment of capital gains taxes as well the depreciation recapture taxes that occur when investors sell real estate or personal property and reinvest in replacement property. 1031 Exchanges effectively work to leverage the amount of capital that is invested in real estate.
1031 Exchange Structures
Simultaneous or Concurrent 1031 Exchange – The relinquished property and replacement property transactions both close at the exact same time.
Delayed 1031 Exchange – Using the services of a qualified intermediary, the taxpayer first sells the relinquished property and subsequently acquires replacement property.
Reverse 1031 Exchange – Using the services of a qualified intermediary, the taxpayer acquires the replacement property prior to selling the relinquished property.
Build-to-Suit (Improvement or Construction) 1031 Exchange – Using the services of a qualified intermediary, the 1031 Exchange proceeds from the sale of the relinquished property are used to acquire and improve the replacement property.
Qualified Intermediary – Because of the complex rules surrounding 1031 Exchanges, most Exchanges employ the services of a qualified intermediary to administer the Exchange. The qualified intermediary should be hired prior to proceeding with any part of the transaction.
1031 Exchange Qualification
Like-Kind Property – The replacement property acquired as a result of a 1031 Exchange must be like-kind property with respect to the relinquished property. Real estate is generally classified as like-kind to other real estate as long as both properties are held for rental or investment or used in a trade or business.
1031 Exchange Reinvestment Requirement
In order to avoid all of the taxable gain – The taxpayer must exchange the relinquished property for property of equal or greater value.
Reinvest 100% of Net Proceeds – 100% of the net proceeds generated by the sale of the relinquished property must be reinvested in the replacement property. Cash can be pulled out, but it will be taxable.
Obtain Equal or Greater Debt – The difference between the total purchase price(s) and the net proceeds reinvested in the replacement properties will always be the correct amount of new debt to place on the acquired properties, unless the taxpayer wishes to invest more cash into the transaction and obtain less debt.
1031 Exchange Deadlines
45-Day Identification Rule – Taxpayers must identify the replacement property by the 45th day following the transfer.
180-Day Exchange Period Rule – After identification, closing on all replacement properties must occur at the end of the 180th day following the transfer. You have exactly 180 calendar days to complete your 1031 Exchange by closing on the purchases of your replacement properties. The 180 days include the 45 days to ID.
1031 Exchange Identification Rules
Taxpayers must comply with one and only one of the following identification rules:
3-Property Identification Rule – A taxpayer may identify up to three (3) potential replacement properties, without regard to their fair market value.
200% Identification Rule – A taxpayer may identify any number of potential replacement properties, but the total aggregate fair market value of the identified properties must not exceed 200% of the FMV of the relinquished property on the date of sale.
95% Exception Rule – A taxpayer may identify any number of replacement properties, without consideration of FMV, but the taxpayer must actually acquire and close on 95% of the fair market value identified.
If you are contemplating a tax-free exchange, please contact us.
John R. Repetti, CPA is a partner with more than 25 years of experience providing expert guidance and advice to international and domestic businesses, as well as numerous family offices and high-net-worth individuals. He can be reached at 347-505-6330 or at firstname.lastname@example.org.Matthew J. Bonney, CPA is a tax partner with over 25 years of experience focusing on all facets of his clients’ business and tax needs. He specializes in working with clients in the real estate sector, including owners/operators, developers, investors, private real estate funds, and REITS. He can be reached at 646-695-7899 or at email@example.com.