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1031 Exchange Guide

8th Jan 2024

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Defer taxes when buying and selling business or investment real estate with a 1031 exchange

The sale of real estate is a taxable event, creating a tax liability for the seller. However, Section 1031 of the Internal Revenue Code allows for taxes to be deferred through a qualifying exchange of like-kind property. By purchasing a property to replace one that has been sold, the taxpayer can defer certain taxes on the sale.

If you are planning to sell a business or investment property and purchase another, Section 1031 may enable you to defer capital gains and other tax liabilities on the transaction. 1031 exchanges have a lot of specific rules that must be followed, and not every property is eligible.

If you have never performed an exchange before, this can seem daunting, but don’t worry. This guide will outline the basics of Section 1031 like-kind exchanges so you can figure out if an exchange is right for you and get the right help to complete your exchange successfully.

1. What is a 1031 exchange?

IRC Section 1031 applies to the sale of real property owned for business or investment purposes. When you sell property, you generally have to pay capital gains taxes, depreciation recapture, sales tax, and other taxes depending on where you live. If your plan is to use your sale proceeds to buy another property, those tax payments can reduce the available capital you have to reinvest.

A 1031 exchange is for those who wish to sell one property (or group of properties) and “exchange” that asset for a “like-kind” property. Exchangers can defer the payment of capital gains taxes and other types of taxes on the sale of their property if they purchase a replacement property in accordance with 1031 guidelines. Those capital gains taxes will not be due until a subsequent property is sold in a taxable sale, allowing you to use all your proceeds to increase your buying power.

For investors, this means they can continue to build wealth by investing in more valuable real estate and put off paying taxes until a later date, making 1031 like an interest-free loan from the government. For the government, it means more capital is invested in job-creating real estate; and when the deferred taxes are eventually paid, they will be calculated based on the sale of more valuable property, generating greater tax revenue. Despite what you may have heard, 1031 is a win-win for the country and for ordinary taxpayers looking to put their money to its best use

2. Who can perform a 1031 exchange?

A 1031 exchange can be performed by anyone who owns property for business or investment purposes. This can include individuals, corporations, partnerships, and trusts in a variety of ownership structures. You can perform a single-property exchange, where one property is sold and another purchased, or a multi-property exchange in which you buy or sell several properties as part of the same exchange.

1031 can be a smart investing strategy for growing small business, managers of multifamily rental properties, owners of short-term vacation rentals, and others who have invested in real estate. There are no minimum requirements for the size or value of the properties involved. As long as you own an eligible property, regardless of whether you own it outright or if you have a mortgage, you can potentially qualify for 1031.

Want to learn more? Read our guide to Choosing the Right Ownership Structure For a 1031 Exchange.

3. What kinds of properties are eligible?

Section 1031 has been a part of the tax code since 1921. For much of its history, it applied to a wide range of property, including depreciable property used by businesses like aircraft, automobiles, and heavy equipment, or intangibles like patents and mineral rights. That changed at the end of 2017 when Section 1031(a)(1) was altered so that 1031 would only apply to “real property.” This eliminated many uses of 1031 for large companies, but for most exchangers dealing in the sale of real estate, 1031 still works as it always has.

The most important restriction on 1031 is that the exchanged properties must be held “for productive use in a trade or business, or for investment,” and not held “primarily for sale.” This means your primary residence will not qualify, nor will undeveloped land purchased to develop and then sell. For a taxpayer’s main home, there is another part of the tax code, Section 121, which offers different benefits and can sometimes be used in conjunction with 1031 for properties that have both a personal and business use. But if you own a property held primarily as an investment, you may qualify for a 1031 exchange.

Want to learn more? Read our blog about the differences between 1031 and 121 and how it’s possible to take advantage of both.

Another requirement is that the exchanged properties must be “of like kind.” Thankfully, in the case of real estate, the “like-kind” requirement is very easy to satisfy: typically, any business or investment property may be exchanged for any other. Single-family residences, multifamily apartment buildings, commercial office or retail space, farmland, warehouses, or even shares in a Delaware Statutory Trust (DST) can be exchanged for one another.

4. Benefits of a 1031 exchange

The key benefit of a 1031 exchange comes in the form of tax deferral. By deferring capital gains and other taxes to a later date, exchangers can reinvest the cash from their property sales that would otherwise have been paid to the IRS into more valuable properties.

To demonstrate this, here’s a simple example involving an individual taxpayer with a $2,000,000 sale, a $1,200,000 gain, 5% closing costs, no indebtedness encumbering the property, and a 23.8% total effective tax rate:

As you can see, by employing a 1031 exchange, this investor is able to put more capital toward the purchase of their replacement property, which will then grow in value as they hold it. Small businesses can use this strategy to upgrade to larger facilities, investing as much as possible in their businesses during crucial expansion periods instead of losing that capital to tax payments.

Want to learn more? Read about How 1031 Can Help Small Businesses Grow.

It is important to understand that tax deferral is not tax evasion. You will eventually have to pay capital gains taxes when you sell a 1031 property as part of a taxable sale, using the original basis from when your first relinquished property was purchased. That said, you don’t have to sell your 1031 replacement property in a taxable sale. You could sell is as part of another 1031 exchange into a third replacement property, continuing deferral as you build wealth. So long as you follow the rules, you can perform as many subsequent exchanges as you like to take full advantage of 1031’s benefits.

To learn more, read our guide to Choosing Between a 1031 Exchange and a Taxable Sale.

The flexibility in the definition of “like kind” can be a useful part of retirement planning. A person who starts out with a single small investment property can gradually exchange into larger and more diverse properties to build up retirement savings. By selling in a taxable sale after retirement, this person’s income would potentially be lower since they are no longer working, possibly reducing their tax burden upon sale. And if they want to continue exchanging, they can target triple-net leases or DSTs to switch to passive investments as they get older.

Want to learn more? Read all about How 1031 Can Help With Retirement Planning.

1031 also provides benefits for estate planning. When you pass, if you leave property to your heirs, they will receive a step up in basis, meaning their tax burden upon sale would be calculated from when they received the property, not when you purchased it. While this benefit may not be available forever, it currently means those who are able to hold 1031 properties until their deaths can effectively eliminate many taxes for their heirs, one more benefit to starting with 1031 now and continuing to take advantage of it over a lifetime.

To learn more, read our guide to 1031 and Estate Planning.

5. What rules apply to 1031 exchanges?

We’ve discussed three basic rules for a 1031 exchange:
1) Section 1031 only applies to real property
2) The properties exchanged must be of like kind
3) The properties must be held for business or investment purposes

But there are also many other rules that apply to 1031 exchanges that come from a variety of sources, including federal statutes, federal regulations, court cases, and IRS guidance, such as revenue rulings, revenue procedures, and private letter rulings. If you do not meet these requirements, your exchange will not qualify for tax deferral, which is why getting the right legal and tax advice is crucial for making the correct decisions for your situation.

One important rule is the use of a Qualified Intermediary (QI), which will be discussed in a later section. It is important to choose a QI that understands all Section 1031 rules so you can achieve your goal of tax deferral.

To learn more, read our blog on How to Select the Right 1031 Qualified Intermediary for Your Exchange.

Some 1031 rules vary based on the type of exchange, including how and when to identify your replacement properties. As the most common type of 1031 exchange is the forward exchange, we will focus on this type of exchange first. We will discuss other exchange types later, but it’s important to remember that every exchange is unique.

6. The forward exchange process

The most common type of 1031 exchange is the forward exchange. This is where you sell your relinquished property before acquiring replacement property. The sale proceeds are held in an escrow account to prevent the taxpayer from having constructive receipt or control, and only released by the QI once the replacement property has been acquired. In a forward exchange, you sell first, then buy.

Forward exchanges are the most frequently-used type of 1031 exchange because of their versatility, ease, and speed of implementation. It would be a mistake to assume, however, that you can sell a property and then decide to begin the process, as there are actions that must be taken upon sale. That’s why it’s a good idea to select a QI before you sell your relinquished property.

Prior to the sale of the relinquished property, the exchanger and the QI enter into an exchange agreement and set up a qualified escrow account at a secure bank to hold the sales proceeds. Upon the sale of the relinquished property, the sales proceeds are wired to the qualified escrow account, which allows distributions only when authorized by both the exchanger and the QI. The funds are held in escrow until they are disbursed to buy the replacement property.

In addition to these rules for control of funds, there are many things you need to do as part of the exchange process, including letting realtors, escrow officers, and mortgage lenders know that your sale and purchase are being executed as part of a 1031 exchange. You’ll need to consult tax and legal professionals to make sure you accomplish all these tasks.

Want to know more? Read our 1031 Exchange Checklist.

For most forward exchanges, you’ll have 180 days from the date of closing on the relinquished property to acquire your replacement property. However, this doesn’t mean you can wait until Day 179 and then purchase any property you wish. You must identify which property (or properties) you plan to acquire as part of your exchange.

The exchanger has 45 days to identify replacement properties in writing or to acquire replacement property without a written identification. If a written identification is made, the exchanger has 180 days from the date of the sale of the relinquished property to complete the purchase of the replacement property. If the 1031 timeline is not followed, the result will be a failed exchange and a return of exchange funds, which will then be subject to taxation.

7. The 1031 exchange timeline

This is the standard timeline for a 1031 forward exchange. The closing date for the sale of the relinquished property is considered to be Day One of the exchange. If more than one relinquished property is involved, Day One is the date of sale of the first relinquished property sold as part of the exchange.

Replacement properties must be identified by Day 45 and acquired by Day 180, with some exceptions. The following actions must be taken before the stated deadlines in order for your exchange to be successful.

Timing Rules

In a forward exchange, the exchanger typically has 45 days from the sale of the relinquished property to identify one or more replacement properties in writing. If the exchanger acquires replacement property without identification within the 45-day period, it is deemed to have been identified.

Identified replacement property must be acquired within 180 days. If a replacement property is not acquired within 180 days, the QI will return the exchanger’s funds and the sale proceeds will be taxed accordingly.

While this is the standard scenario, you may not have the full 180 days to complete your exchange. If the due date (including extensions) of the taxpayer’s tax return for the taxable year in which the relinquished property was transferred to purchase a like-kind replacement property comes before Day 180, that tax return due date becomes the deadline for the exchange.

Here’s an example to better understand how this can happen. Let’s say you sell your replacement property on December 31st. Under standard 1031 rules, you would then have 180 days to acquire replacement property. But let’s imagine your tax return is due on April 15th. Since this is less than 180 days, you will now only have until April 15th to purchase your replacement property, a considerably shorter amount of time than 180 days.

Not all exchanges can use the standard 1031 timeline. This is why it’s important to understand the specifics of your exchange scenario and get advice from professionals who understand your unique situation.

Identification Rules

In a forward exchange, one or more replacement properties must be identified in writing by Day 45. You can identify up to three properties, regardless of their individual or fair market value, and do not have to ultimately purchase all of them. For this reason, it’s a good idea to use all three identification slots in case one or more of your properties falls through.

Though the three-property rule is standard, there are some situations in which it’s possible to identify more than three properties. A variation called the “200% rule” allows you to identify any number of properties provided their aggregate fair market value does not exceed 200% of the value of all relinquished properties. There is also the “95% rule,” which allows you to identify any number or value of properties if you acquire property of fair market value which is at least 95% the aggregate fair market value of all properties identified.

These additional rules and exceptions are complex and don’t apply to everyone, so we won’t cover them in detail here. To learn more, see our guide to the 1031 Exchange 45-Day Identification Deadline.

Outside of these exceptions, the 45-day and 180-day deadlines are not flexible and must be met for a forward exchange to be successful. But a forward exchange is just one type of exchange – you do not have to sell your relinquished property before identifying a replacement property. There are other kinds of 1031 exchanges that may work better depending on the exchanger’s individual situation.

8. Other types of 1031 exchanges
Reverse exchange

A 1031 reverse exchange provides the same tax benefits as a 1031 forward exchange, but with one major difference: a reverse exchange enables you to buy first and then sell.

In a reverse exchange, the replacement property is purchased before the relinquished property is sold. Instead of identifying potential replacement properties, you must identify the relinquished property, and instead of the QI holding sales proceeds, the title must be held. The time frame is the same as a forward exchange, but the process is reversed.

A reverse exchange is useful for situations where a desired property becomes available unexpectedly, or in a competitive real estate market in which it is easier to find a buyer than a suitable replacement property. The drawback of a reverse exchange is that you won’t have access to the sales proceeds when you purchase the replacement property, meaning greater capital requirements during the exchange.

The IRS has issued guidance to provide “safe harbors” under which a reverse exchange can be performed. When the replacement property is purchased, the QI acquires title to the replacement property and “parks” it until the relinquished property can be sold.

The exchanger has 45 days after the replacement property is parked to identify their relinquished property in writing or to sell their relinquished property without a written identification. If a written identification is made, the client has 180 days from the parking of the replacement property to complete the sale of the relinquished property.

Reverse exchanges are less common and not all Qualified Intermediaries have experience with the procedures of the parking arrangements. In order to create a safe harbor parking arrangement, you need to enter into a specific type of agreement (known as a Qualified Exchange Accommodation Agreement, or QEAA) with the Exchange Accommodation Titleholder (EAT), who then holds title to the parked property, typically in a single-member limited liability company, until it is transferred to the exchanger.

It’s possible for the exchanger to lease the parked property from this LLC during the exchange period in order to build improvements upon it. It is also possible to have a non-safe-harbor parking arrangement with less strict rules, though there is also less IRS guidance on proper procedure. You can also structure a reverse exchange so that the EAT parks the relinquished property from a forward exchange and holds it until it can be sold.

All of that is to say that a reverse exchange requires specific expertise. JTC has extensive experience in reverse exchanges and works with our clients’ tax and legal advisors to determine the proper structure under which to execute a reverse exchange properly.

Go here to learn more about JTC’s 1031 Reverse Exchange services.

Simultaneous exchange

While a forward exchange involves selling first, then buying, and a reverse exchange involves buying first, then selling, it’s also possible to perform a simultaneous 1031 exchange in which the relinquished property is sold and the replacement property acquired at the same time.

The benefit of this scenario is that it eliminates the worries of the 1031 exchange timeline. You won’t have to concern yourself with identifying properties within 45 days like in a forward exchange, and you won’t have to provide the additional capital required for a reverse exchange.

A simultaneous exchange provides greater assurance that the exchange will be completed because no property is sold or purchased before the entire exchange is arranged. For example, you may find a replacement property, but worry about the buyer of your relinquished property falling through. A simultaneous exchange would allow you to make your purchase of the replacement property contingent upon sale of the relinquished property, so that if either transaction falls through, you can back out of the exchange and continue to hold your relinquished property, avoiding a potentially costly tax burden.

The downside to a simultaneous exchange is that it requires careful coordination with all parties involved. You may not find a buyer and seller who are both willing to close at the same time, and therefore will have to take on the added risk of a delayed exchange scenario. But if you’re able to make a simultaneous exchange work, it can mean completing your exchange faster and with less uncertainty.

Improvement exchange

Sometimes referred to as a construction exchange or a build-to-suit scenario, an improvement exchange allows the exchanger to use some of their sales proceeds to make improvements to the replacement property, or even build new structures on it.

All improvements must be completed by Day 180 in order for exchange funds to be used for them, so plans for construction and repairs will need to be carefully worked out in advance. The property also must remain substantially the same, meaning you can’t drastically change its use. But in scenarios where alterations need to be made before a business can operate in the space, an improvement exchange can allow exchangers to make necessary improvements right away.

Delaware Statutory Trusts

Another option is to use a Delaware Statutory Trust as a replacement property. A DST is a passive real estate investment in which a group of investors buys a property (or properties) and a professional property manager oversees the management of the portfolio of properties.

A DST has many advantages. Having a professional property manager means you don’t have to actively manage the property, and with the combined purchasing power of many investors, a DST can acquire property of greater value and at more favorable loan rates than an individual, offering instant diversification and consistent income through distributions from the trust.

A Delaware Statutory Trust is a great option to use as one of your identified properties in a forward exchange because there is less risk of the deal falling through since you’re purchasing a proportional interest rather than a single property. If you’re unable to close on your other identified properties, you’ll still have the identified DST as a backup.

Whether you’re looking for a backup option or seeking to exchange into a passive investment, DSTs are worth learning about. JTC provides QI services for exchanges into and out of DSTs, which can qualify as like-kind properties under Section 1031.

Want to learn more? Read our blog post where we answer Common Questions About Delaware Statutory Trusts.

9. What is a “boot” in a 1031 exchange?

In many exchange scenarios, the replacement property is of equal or greater value to the relinquished property, but this isn’t always the case. If your replacement property is worth less than your relinquished property, you will have some exchange funds left over, which will be returned to you after the exchange. This is known as the boot and will be subject to taxation.

If you want to avoid a boot, you’ll need to structure your exchange carefully. One way is to ensure your replacement property is valued higher than your relinquished property. You can also choose a second property, such as a DST, in which to invest the remaining funds.

There are different kinds of boots, including a cash boot (where there is leftover cash from the exchange) and a mortgage boot (where all cash has been used, but debt obligations have been reduced). Properly calculating your taxable boot in advance can help you avoid being surprised at tax time.

Want to lean more? Read our guide to Avoiding a Boot in a 1031 Exchange.c

10. What is a Qualified Intermediary?

All exchanges require the use of a Qualified Intermediary (QI). In a forward exchange, the QI holds the sale proceeds in an escrow account until the replacement property is purchased. If a replacement property is not purchased, funds can be released to the exchanger on Day 180.

For reverse exchanges, IRS regulations outline how to transact a “safe harbor” exchange. Prior to the exchange, the exchanger generally enters into a written agreement with the QI, which creates the “exchange” that enables the exchanger to obtain tax deferral treatment for the sale of his relinquished property.

The QI must also be assigned the exchanger’s rights, but not obligations, to the relinquished property sale agreement and to the replacement property purchase agreement in order for those properties to be transferred directly to the buyer or seller. The other parties to each agreement must be notified of such assignments prior to the transaction covered by that agreement.

A QI must not be a “disqualified person,” which includes:

  • Any person who acts as the agent of the exchanger at the time of the exchange, including someone who has acted as their employee, attorney, accountant, real estate agent or broker or investment banker or broker during the 2-year period ending on the date of the transfer of the first relinquished property
  • Any person related to the exchanger within the meaning of IRC Section 267(b) or 707(b), which includes certain types of close relationships among family members, partners, partnerships, shareholders, corporations, beneficiaries, trustees, and executors
  • Any person related to an agent of the exchanger within the meaning of IRC Section 267(b) or 707(b) using a 10% test instead of the 50% test
11. The JTC Advantage

We’ve discussed the principal rules applicable to the two main types of Section 1031 exchanges, but there are many other highly nuanced rules that may apply depending upon the exchanger’s individual situation. Some of these rules involve liability (mortgage) netting, sales to or purchases from persons or entities related to the exchanger, “drop and swaps,” and domestic versus foreign property exchanges. Again, whether or not these issues present a challenge to the exchanger depends upon the exchanger’s tax situation and the complexity of the exchange.

Want to learn more? Read our factsheet about How to Perform a 1031 Exchange.

One of the most important steps towards a successful exchange is selecting the right QI. At JTC, we’ve pioneered best practices for Qualified Intermediaries, focusing on three key areas:

Security of funds
  • The QI should never be on the title when overseeing client funds
  • Any fund movement requires dual approval by the exchanger and the QI
  • Exchange funds are only held:
    • In FDIC-insured, fully liquid accounts
    • In individual qualified escrow accounts, never commingled in operating accounts
  • Errors and omissions and cyber insurance and a fidelity bond should be provided for added protection.
Transactional transparency
  • All account information should be accessible in real time, from anywhere, including:
    • Account balances
    • Account locations
    • Rate of return on deposits
    • Applicable fees
      • Persistent event recording and document storage
      • Audit trail feature for streamlined report creation
      • Archived documentation available to view, download, or print, 24/7
  • Secure, password-protected web access
Regulatory compliance

To ensure compliance with federal standards for financial controls, privacy and reporting, QIs should submit to an annual audit of their business practices and technologies. In addition to IRC Section 1031 and IRC Section 468B, exceptional QIs comply with:

  • SOC 1 Type 2 certification
  • Sarbanes-Oxley 404 controls
  • Gramm-Leach-Bliley Act
  • The Bank Secrecy Act

At JTC, we’ve built an industry-leading track record of 1031 success thanks to our commitment to best practices and technology-based solutions. Our legal and Client Services teams have experience in all manner of exchange scenarios, and our secure online platform provides visibility at every step.

Benefits of Working with JTC
  • 24/7 online access to exchange information from anywhere in the world
  • Comprehensive audit trail
  • Dedicated Client Services team
  • Exchange funds are only held in FDIC-insured, fully liquid accounts at highly-rated banks, never commingled with operating accounts
  • Errors and omissions and cyber insurance
  • Automated document management
  • Dual-authorization disbursement of funds
  • Experience with complex exchange scenarios like reverse exchanges and those involving Delaware Statutory Trusts
12. Want more information?

Still have questions about Section 1031 like-kind exchanges? Interested in learning more about JTC’s QI services?

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