What is a 1031 Exchange?

posted on October 11, 2018

A 1031 exchange, also known as a Starker or like-kind exchange, is a powerful tax deferment procedure that permits investment property owners to sell real estate they currently own and buy like-kind property while deferring capital gains tax. 

A 1031 exchange is named for the Internal Revenue Code tax section that states:

In this post we’ll cover the key points of a 1031 exchange including the rules and definitions you should know before proceeding.

The Powerful Protection of a 1031 Exchange

It’s critical to understand the terms used in a 1031 exchange. For instance, many people mistakenly believe “like-kind” means you must buy a property exactly like the one you sold. But what matters under the code is that the asset be held for investment or for use in a business or trade, and that it not be a personal residence. For example, timberland is considered real property for 1031 exchange purposes, which means as long as all other conditions hold true, you can exchange it for a rental condo.

One important caveat: If the property you’re relinquishing is in the U.S. or its territories, the replacement property must also be located there as well.

There are also timing considerations. For example, you must identify the new property or asset you’re purchasing within 45 days of the sale of your existing property (more on timing in the conclusion).

Tax-deferred exchanges allow you as an investor to defer capital gains taxes and facilitate meaningful portfolio growth and increased return on investment. Case in point:

• You sell an investment property and realize a $500,000 in gain and the same amount in post-close net proceeds.
• A $500,000 capital gain would typically incur a tax liability in combined taxes of approximately 30%, or $175,000, when you sell the property (this is an estimate as taxes vary by state). The remaining $325,000 net equity is all you have left to reinvest in another property.
• With a 1031 exchange, you can reinvest the entire gross equity of $500,000 in a replacement property that is worth more and can reasonably be expected to earn you a greater return.

Reasons for Choosing a 1031 Exchange

There are several reasons for choosing a 1031 exchange investment. You may want:

• A property with better return prospects
• To diversify assets
• To invest in a managed property rather than managing one yourself
• To consolidate several investment properties into one, or to go from a single property into several assets

One important caveat to 1031 exchanges: They can require comparatively high minimum investments and holding times. For that reason, a 1031 can be more ideal for individuals with higher net worth.

Simplified Group Investment

There are two important ways using a DST makes owning investment real estate less stressful.

1. Because your agreement is with the trustee of the DST, you’re not threatened by the actions of any other investor. You have the advantage of sharing the investment burden but are shielded from liability with respect to the underlying investment property and have none of the risk associated with a rogue investor.
2. A DST is less expensive than a TIC (tenant-in-common), there’s only one agreement you need to execute, and there’s no need for a special purpose entity to be formed and maintained. A single loan is made to the DST trustee, not to each investor. And because there is no IRS-imposed limit on the number of investors in a DST (TICs are limited to 35), the minimum required investment can be much lower, providing you the opportunity to diversify into more than one DST.

The Role Qualified Intermediaries Play

Qualified intermediaries, also known as accommodators, facilitate 1031 tax-deferred exchanges.

Remember, under section 1031 of the IRS tax code, any proceeds from the sale of an investment property remain taxable. When you decide to do a 1031 exchange, the proceeds from the sale of your existing property cannot be transferred to you personally; they must transfer to a qualified intermediary, a “disinterested” third party who enters into a written agreement with you and:

• Acquires the relinquished property from you.
• Transfers the relinquished property to a buyer.
• Acquires the replacement property from the seller.
• Transfers the replacement property to you.

The logic behind this procedure is that since you, as the taxpayer, do not take actual receipt of the sales receipts, no capital gains taxes are triggered. It’s also the reason you cannot use a CPA or attorney as an intermediary, as they are “interested” parties working on your behalf. (You cannot use your own CPA or attorney if they have represented you in the past two years.)

A qualified intermediary can reduce the complexity of an exchange and provide you with the proper guidance and information you need for a successful transaction.

Conclusion

There are other factors you need to consider before investing in a 1031 exchange. As mentioned, timing and various other rules apply. You must:

• Sign an exchange agreement with the qualified intermediary before closing on the relinquished property.
• Identify the potential replacement property(s) by midnight of the 45th day following the closing on your relinquished property.
• Close on the replacement property(s) by midnight of the 180th day following the closing on the relinquished property or when your federal taxes are due. If sooner, an extension can be filed to extend the time to close to the full 180 Days.
• The 45 day and 180 day requirements are calendar days and are not extended for weekends or holidays.

There are expenses and fees involved as well, some of which can be paid with exchange funds while others may not. And estate-planning considerations must be addressed.

The tax deferment you realize with a 1031 exchange is a wonderful investment opportunity for you and your heirs. Though it can be a complex process, those complexities are what also give it its great flexibility. For this reason, it’s not a procedure for investors acting on their own. Competent professional assistance at every step ensures a smooth and legal exchange.

Turner Investment has extensive experience in managing the entire 1031 exchange process for our clients. We work with you to provide the right replacement assets when you need—and want—them most. To learn more about 1031 exchanges and whether using one is the right choice for you, contact us today. We’d love to talk with you about your investment options.

Disclaimer