What is a 1031 exchange?
A 1031 like-kind exchange is a tax and reinvestment strategy that allows you to reinvest the proceeds from the sale of real estate into new real estate, without triggering capital gain taxes or depreciation recapture taxes at the time of sale.
The primary reason to execute a 1031 exchange is to redeploy capital into investments that are greater in scale, more diverse, or more aligned with your current investment strategy. And because taxes are deferred, more of the sale proceeds can be immediately directed toward your new investment.
Many investors can benefit from deferring the tax liability associated with the sale of investment real estate through a 1031 exchange. However, there are strict regulations and guidelines to be aware of that dictate what constitutes a valid exchange. Six important rules to be mindful of are discussed below.
Six 1031 exchange rules you need to know
1. You must exchange into “like kind” property.
The regulations state that the exchange must be between qualifying properties of “like kind,” but the property type does not necessarily determine this qualification. For example, you may invest in a multifamily building if you sold an industrial building. Most real estate held for use in a trade or business or for investment will qualify for an exchange. However, properties held primarily for personal use, such as a vacation home, generally do not qualify.
2. You must engage a qualified intermediary before you close.
This is one of the most common mistakes investors make.
The sale must also go through a qualified intermediary: an independent organization that will handle the funds from the original sale through the exchange process and then deliver the money to the closing agent. The qualified intermediary must be engaged before you close on the relinquished property. Once you touch the proceeds, the exchange is dead.
The qualified intermediary will also be responsible for filling out the exchange agreements related to the process, and you or your certified public accountant will need to file all necessary tax forms.
3. You must meet two deadlines: 45 days and 180 days.
The 1031 exchange timeline is very strict. In order for the 1031 exchange to be valid, replacement property options must be identified in writing, with your signature, and delivered to the qualified intermediary no more than 45 days from the date the relinquished property is sold. In most cases, you must close on the purchase of your replacement property within 180 days of that same sale date. These two periods run concurrently rather than consecutively.
One commonly overlooked nuance is that the 180-day window can be cut short by the due date of your tax return for the year of the sale, so late-year transactions typically require filing an extension to preserve the full period.
4. You must limit how many replacement properties you identify.
The number of replacement properties you can identify during the 45-day identification period is constrained.
For simplicity, most investors identify no more than three replacement properties, which can be of any value. If you want to identify more than three, you may do so as long as their aggregate fair market value does not exceed 200% of the fair market value of the relinquished property. If you ignore these constraints, the identification will only remain valid if you acquire at least 95% of the aggregate fair market value of all properties you identified.
In practice, this means closing on essentially everything on the list, so a single failed deal could void the entire exchange. This approach is rarely used on purpose and is regarded as a last resort to correct a mistake in the identification process.
5. You must buy a replacement property at or above your sale price.
The total net purchase price of the replacement property you’re acquiring must be equal to or greater than the total net sales price of the relinquished property. If your replacement property’s purchase price is less than your relinquished property’s sale price, you will be taxed on the portion not reinvested, known as “cash boot.”
6. You must reinvest all equity and replace any debt.
The net equity in your replacement property must also be equal to or greater than the net equity in the property you sold. Any decrease is taxable. Debt is part of that equation. If the mortgage on your replacement property is less than the debt retired on the property you sold, the shortfall is treated as “mortgage boot” and is taxable even if you reinvest all of your cash proceeds. You can close that gap by placing new debt on the replacement property or contributing an equal amount of out-of-pocket cash.
1031 exchanges in the current real estate market
Investors face several challenges when attempting a 1031 exchange to defer taxes on gains incurred on the sale of a property, including:
- Finding quality investment properties in an increasingly uncertain and competitive market
- Replacing debt without contributing additional cash, particularly in a higher interest rate environment
- Sellers leveraging your 1031 deadlines and process to their advantage
- Choosing the right qualified intermediary
Planning with a real estate investment consultant and a tax advisor is essential to successfully executing a 1031 like-kind exchange. Every investor’s situation is different, and each situation can trigger different nuances within the rules discussed in this article.
An unbiased real estate professional can lay out all your options to help determine whether a 1031 exchange is feasible. We can also advise if certain other strategies — like a “reverse 1031 exchange,” Delaware Statutory Trust, opportunity zone investment, or cost segregation study — are appropriate for you.
If you’re interested in learning how to do a 1031 exchange for your investment property, contact our team today. We can help navigate these challenges and proactively identify properties before you sell to increase the likelihood of success of your 1031 exchange. Our in-house multidisciplinary team of tax, real estate, and investment professionals will help you make an informed decision.
Opinions expressed in this article are current as of the date of this article, and are subject to change at any time.
Plante Moran Realpoint Investment Advisors publishes this content to convey general information about our services. Investments and strategies mentioned herein may not be appropriate for you. Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain. You should consult a representative from Plante Moran Realpoint Investment Advisors for advice regarding your own situation.
