As a commercial mortgage broker,my job is not only about arranging financing for my clients’ deals. I also takegreat pride in helping my clients understand the various tools for maximizingthe value of their investments. One of those tools is the 1031 exchange, anoften-overlooked way of deferring capital gains tax and in turn, growing yourreal estate portfolio.
In today’s article, we take a deep dive into 1031 exchanges – including thetypes of 1031 exchanges and common 1031 exchange pitfalls for investors toavoid. This guide is intended for real estate investors as well as commercialreal estate agents, attorneys and other mortgage brokers looking to help theirclients better understand how 1031 exchanges work.
Read on to learn more.
What is a 1031 Exchange?
One of the primary reasons people invest in commercial real estate is becauseit is a highly tax-advantaged industry. There are several reasons why this isthe case, one being the tax savings associated with doing a 1031 exchange.
In theory, the 1031 concept itselfis simple: Reinvest the proceeds from the sale of business or investmentproperty into a like-kind investment in order to defer paying capital gainstax.
Doing so increases an investor’spurchasing power because he can use 100% of his current property equity toinvest in a replacement property. Using a 1031 exchange is a great tool forinvestors looking to grow their real estate portfolios.
In reality, 1031 exchanges arequite complex. Section 1031 of the Internal Revenue Code (from which the termgets its name) contains many nuances that can be daunting to those unfamiliarwith how these exchanges work.
Types of 1031 Exchanges
Most real estate investors arefamiliar with a “delayed exchange,” the most common form of 1031 exchange. Yetthere are actually five different forms of 1031 exchanges, and each can be usedfor different purposes.
1. Simultaneous Exchange
The Simultaneous Exchange was the original 1031 exchange, andallows investors to swap properties directly, relinquishing and closing ontheir replacement property within the same day – hence the name “SimultaneousExchange”. With this type of exchange, two parties literally exchange the deedsand other necessary documents to trade assets, simultaneously transferringownership to one another. No monetary compensation is allowed.
This is the oldest type of 1031 exchange, though it is rarely usedtoday given the operational complexities. Most investors have a difficult timefinding an investment property that they want to buy, a property that happensto be owned by someone who ALSO has an interest in trading for their investmentproperty. On the off chance an investor engages in a Simultaneous Exchange, hemay use a qualified intermediary (see below) to handle the transaction, thoughthe IRS does not require him to do so.
2. Delayed Exchange
The Delayed Exchange is the most common type of 1031 exchange. ADelayed Exchange is one in which a third party, known as a “QualifiedIntermediary” (QI), facilitates the selling of one’s property and assures thatproceeds are used for the acquisition of another like-kind property. Upon theQI’s receipt of money from the sale of a property, an investor has 45 days toformally identify which replacement property (or properties) he wants to buy.
In order for a replacement property to be considered valid underthe rules of the Delayed Exchange, it must meet one of the three following criteria:
The “exchange period” is an important deadline investors mustmonitor while doing a 1031 exchange. An investor only has 180 days from thedate he closes on the relinquished property to close on the replacementproperty, otherwise known as the exchange period. The transaction must besettled within 180 days for the Delayed Exchange to be considered successful.These 1031 rules are critically important for investors to follow.
Expect to pay between $750 and $1,250 to hire a qualified intermediary whendoing a Delayed 1031 Exchange.
3. Improvement Exchange
An Improvement Exchange allows an investor to make improvements ona new replacement property using his tax-deferred equity prior to closing onthe replacement property. This type of exchange is also referred to as a“construction” or “built-to-suit” exchange. It is particularly useful for investorswho are interested in acquiring a property that is not of equal or greatervalue than the property they intend to relinquish; for investors willing totake on the ground-up construction of their new replacement property; or forinvestors who have identified a property of equal or greater value that is inneed of significant improvements. Improvement Exchanges are complicated, butoften result in an exchanger finding a better investment than he couldotherwise find on the open market.
Improvement Exchanges have a few basic requirements. First, allexchange equity must be spent on improvements by the end of the 180-dayexchange period (even if construction is not complete). Second, the exchangermust receive substantially the same property he identified during the 45-dayidentification period. And finally, the replacement property must be of equalor greater value than the relinquished property at the time of transfer to theexchanger.
4. Personal Property Exchange
The Personal Property Exchange involves the sale of a personalasset to invest in another like-kind asset. It may be a tangible asset (e.g.vehicles, artwork, office furniture) or intangible (e.g. business licenses,copyrights, website URL). Investors are urged to review the North AmericanStandard Industrial Classification manual to determine whether a specific formof personal property qualifies for this type of 1031 exchange. These exchangesmust also adhere to the strict 180-day exchange period.
Personal Property Exchanges are often used in conjunction withother forms of 1031 exchanges in order to sell personal and real property atthe same time. This is common when a 1031 exchange includes the sale of hotels,restaurants and gas stations wherein the exchanger owns both the building/landand the personal property contained therein.
5. Reverse Exchange
All of the aforementioned types of 1031 exchanges are considered“forward” exchanges. The outlier is the Reverse 1031 Exchange, which is usedwhen an investor acquires a replacement property before conveying therelinquished property to the new buyer. These are the most complicated forms of1031 exchanges, and most would argue the riskiest. This is because an investoris still obligated to find and close on a replacement property within the 45- and180-day timelines. Some investors will struggle to complete the process within180 days if another property has not yet been identified. There are otherstrict guidelines associated with the Reverse Exchange. For instance, aninvestor can never own the two properties simultaneously, which requires theinvestor to “park” legal title to one of those properties with a QI until thetransaction is complete.
That said, a Reverse Exchange can be incredibly useful for aninvestor who need to act quickly. An investor may need to act on an opportunitybefore he has had time to even consider listing or selling the property heintends to relinquish. Alternatively, the sale of the relinquished property mayfall through and an investor may still want to move forward with the propertyhe intended to purchase using a forward 1031 exchange.
Expect to pay anywhere from $3,500 to $7,500 to hire a qualified intermediarywhen engaging in a 1031 Reverse Exchange.
Defining a “Like-Kind” Investment
The IRS considers “like-kind”property as any property used in a trade or business as an investment. Itgenerally refers to real estate: single family, multifamily, commercial,retail, industrial, condos, hotels and raw land are all examples. It also refersto personal property used for business purposes, such as vehicles, airplanes,office furniture, business equipment and even livestock. Personal property canbe traded directly through the Personal Property Exchange, though personalproperty is most often traded in conjunction with some form of real estate.
The term “like-kind” can besomewhat misleading. An investor who sells an apartment building is notrequired to purchase another apartment building. He can exchange that apartmentbuilding for raw land or a strip mall, if he so chooses—as long as that type ofproperty is eligible for exchange.
Stocks, bonds, securities,certificates of trust, interests in partnerships and business inventoryintended for sale are examples of property that cannot be sold using1031 exchanges.
Adding “Boot” to a Deal
There are some situations in whicha 1031 exchange includes the transfer of property that is not consideredlike-kind. For example, the sale might include a cash payment to be used towardcapital improvements at the replacement property. This is called “boot”.Because the cash is not considered like-kind property, an investor may beresponsible for paying taxes on the boot portion of the exchange.
An investor might also use boot toreduce the mortgage liability on the replacement property below the mortgageliability on his relinquished property. This is known as “mortgage boot.”
In order for an investor to deferall of the capital gains on his relinquished property, he must purchase aproperty of equal or greater value. He must also reinvest ALL cash proceedsfrom the sale into the new property.
Contrary to popular belief, aninvestor does NOT have to place debt on the replacement property equal orgreater to the debt that was paid off on the relinquished property (though hemay). An investor can always add debt or place more cash into the purchase of alike-kind replacement property as long as proceeds from the sale have beeninvested in their entirety.
As a general rule of thumb, alwaysremember: “trade up” and “no cash out”.
When NOT to Use a 1031 Exchange
Although we’ve touted the benefitsof using a 1031 exchange, there are some circumstances in which it might not beappropriate. For example, investors generally do not want to use a 1031exchange when they have experienced a loss on the property. Instead, they will wantto recognize those losses for income tax purposes. Just as capital gains aredeferred using the 1031 exchange, so are losses. Deferring losses that wouldotherwise offset large profits could outweigh the benefits of using a 1031exchange.
1031 Exchange Pitfalls to Avoid
Any investor considering using a1031 exchange to defer paying capital gains tax should familiarize themselveswith the most common pitfalls. The IRS 1031 exchange rules are complicated, andeven the slightest mistake can dismantle a successful transaction.
Whatif you used to live in the primary residence but now use it as aninvestment property? If you have lived in the property for two out of the lastfive years, then you do not pay capital gains tax (up to $250,000 or $500,000for a married couple). In this case, you cannot engage in a 1031 exchange.However, if you lived in the home for less than two of the past fiveyears, it is no longer considered a primary residence and you may sell using a1031 exchange. Any capital gains on the period the property was used as arental becomes the basis for the 1031 exchange.
There are obviously several benefits to utilizing a 1031 exchange: youcan defer paying capital gains tax, you can increase purchasing power wheninvesting in another like-kind investment, and you can begin to scale your realestate portfolio. Savvy real estate investors use 1031 exchanges all the time.
But 1031 exchanges are also quite complicated. It is always best to have yourCPA and/or real estate attorney guide you through this process. This willensure you are meeting all 1031 obligations and fulfilling all 1031 rules accordingto IRS guidelines.
Are you interested in using a 1031 exchange to grow your real estate portfolio?Contact us today. We can discuss how 1031 exchanges, when used alongside otherattractive real estate financing tools, can be used together to maximize thevalue of your investments.