What Is A 1031 Exchange?

A 1031 exchange (also called a Starker or like-kind exchange) is the exchange of one business or investment for another. Most exchanges of this nature are taxable as sales, but if this section of the United States Internal Revenue Code applies, the tax on the capital gains can be deferred into the replacement entity. In other words, there would be no tax or limited tax due at the time of the exchange.

In effect, you can change the form of your investment without realizing capital gains. This means that your investment can continue to grow, tax-deferred. The most common application of a 1031 exchange is for real estate, but it can apply to other investment and business assets as well. As long as the money continues to be re-invested in a like-kind entity, the capital gains taxes can be deferred.

The simplest version of a 1031 exchange is a simultaneous exchange of investment assets. In 1979, the decision in the benchmark case Starker V United States expanded the coverage to include non-simultaneous real estate exchanges as well. This allows you to dispose of property and then subsequently acquire one or more like-kind replacement properties. The benefits of a 1031 exchange apply to these deferred exchanges so long as replacement property is identified within 45 days of closing, and acquired within 180 days of closing.

 

1031 Exchange Example:

To understand the power of a 1031 exchange, consider the following example:

An investor has a property that is going to bring in a $100,000 capital gain. When that property sells, say it incurs a combined tax liability of approximately $35,000. This is due to depreciation recapture, net investment income tax, federal capital gain tax, and state capital gain tax. This means that only $65,000 in net equity remains to reinvest in another property.

If the same investor chose to exchange investments rather than cashing out, they would benefit from the 1031 exchange which would make the capital gain tax deferrable. They would then be able to reinvest the entire gross equity of $100,000 in the replacement investment property.

 

1031 Exchange Rules and Requirements:

There are certain requirements in place that you must meet to be eligible for a 1031 Exchange:

• Both the relinquished and replacement properties must be held primarily for investment or business purposes.

Personal residences cannot be exchanged. There are restrictions in place that determine eligibleity for personal property.

• The properties exchanged must be of “like-kind”.

Like-kind is a key term here. It means that properties must be of the same nature and character, even if they differ in quality. Personal properties of a like class are like-kind properties. As an example, a truck and a car would not be considered like class. Personal property used predominantly in the United States and personal property used predominantly elsewhere are also not like-kind properties.

Real properties are generally of like-kind, regardless of whether the properties are improved or unimproved. A broad definition of real estate applies and includes land, commercial property, and residential property. However, just like with personal property, a real property within the United States and a real property outside the United States would not be like-kind.

• Deferred exchanges must follow additional regulations:

If the exchange is going to be deferred, (that is the relinquished property is being sold before the replacement property is obtained), there are certain timing and process regulations that must be met in order for the transactions to qualify as a 1031 Exchange. The taxpayer must:

• • Identify the property you are relinquishing for exchange before closing on its sale.
  • Identify the replacement property within 45 days of closing.
  • Acquire the replacement property within 180 days of closing.
  • Use a qualified intermediary to facilitate the transaction. The intermediary must hold all the profits from the sale of the relinquished property, and then disburse those profits after closing on the replacement property.
  • Properties must be “mutually dependent parts of an integrated transaction.” This is distinguished from the case of a taxpayer selling a property and using the proceeds to purchase another property, as this would be a taxable transaction.

• Multiple properties can be identified as replacement properties in certain situations:

There are separate rules in place for this circumstance as well. These Regulations establish 3 different sets of rules that may be used to identify qualified replacement properties:

• • 3 Property Rule –  Up to 3 like-kind properties can be identified as replacement property without regard to the market values. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
  • 200% Rule – Any number of like-kind properties can be identified as replacement property so long as the aggregate value of the replacement properties does not exceed 200% of the value of the relinquished property. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
  • The 95% Rule – Any number of like-kind properties can be identified as replacement properties, but at least 95% of the properties identified must be purchased or the entire exchange is invalid.

1031 Exchange Exclusions:

Certain types of property exchanges are not eligible for Section 1031 treatment:

• Dealers: If a property is being held for resale or as inventory by a dealer, it is not eligible for Section 1031 treatment. However, if a taxpayer is a dealer and also an investor, he or she can use Section 1031 on qualifying properties.
• Primary Residences: Primary residences are not eligible for Section 1031 treatment because they are not investment or business properties.
• Vacation homes: A vacation home can qualify as a 1031 Exchange, but only in certain circumstances. There are a series of rules and a safe harbor around this. Essentially, you cannot use your 1031 replacement as a primary residence for a number of years. For two years you have to rent the home out for at least 14 days and the amount of time you spend in the home also cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

The IRS also outlines these additional exclusions:

• Inventory or stock in trade
• Stocks, bonds, or notes
• Other securities or debt
• Partnership interests
• Certificates of trust  

 

In Summary…

1031 Exchanges can provide huge benefits to taxpayers when understood and applied correctly. There is no limit to how many times you can do a 1031 exchange. This means the tax deferral can continue to roll over again and again. This allows you to avoid capital gain tax until you actually sell for cash many years later. At that point, hopefully, you will only have to pay one tax at a long term capital gain rate (currently 15%). If you have questions about how a 1031 exchange works or if you are wondering if your property may be eligible, reach out to one of our knowledgeable agents today.