1031 Exchange — The Basics

What is a 1031 exchange? What are its pros and cons? Clients ask me this question at least a couple of times each month, and I think it’s time for a simple answer.

With respect to real estate transactions, a 1031 exchange is a way for you to sell your investment property and use those funds to buy another investment property, without paying any capital gains tax on the property you sold for the time being. Pursuant to Internal Revenue Code Sectin 1031, the real estate you sell and the real estate you purchase must both be in the United States to qualify for a 1031 exchage. Sounds great, right? But there are a few things you should be aware of:

1) A 1031 exchange must be arranged prior to the closing of your sale. Your real estate attorney should be notified in advance so she can make arrangements for the title company to transfer funds directly to one of the many companies that handle 1031 exchanges. These companies are known as Qualified Intermediaries. Paperwork must be completed at or prior to the closing by both parties to the transaction, and you will have to pay a fee to the Qualified Intermediary. You CANNOT take the proceeds of the sale home with you, or have it wire transferred to your account, and then decide later that you want to do a 1031 exchange. For the exchange to be valid, the funds must be transferred to a 1031 company at closing.

2) Within 45 calendar days of your closing, you must identify up to three properties that you are interested in purchasing with your 1031 money. If you would like to, you can identify more than three properties, but then you are subject to the 200% rule, which means that that the total value of everything you identify has to be less than twice the value of the property you have sold. If you don’t identify any properties within 45 days, the 1031 exchange fails and you can request the Qualified Intermediary to refund your money. If you identify properties and later decide you don’t want to purchase any of them, you must wait until 180 days have lapsed from the time you sold your property to get your money back.

3) The closing of any new property or properties that you are purchasing using the the 1031 money MUST close within 180 calendar days of the property you sold. If you do not close within that time frame, the 1031 exchange fails, and you can request the Qualified Intermediary to refund your money.

4) The same entity that sold the initial property must be the buyer of the new property. For example, Joe Investor sells his apartment building and deposits the money with a Qualified Intermediary to do a 1031 exchange. Joe finds a shopping plaza he is interested in purchasing, and decides to form a company, Superstores LLC, to purchase the shopping plaza. Joe cannot do this. If Joe Investor sold the building, Joe Investor must be the buyer of the shopping plaza. This requirement makes it especially difficult when a company with multiple owners sells a property. Oftentimes, one of the owners wants to complete a 1031 exchange, but the other owners do not.

5) The new property or properties must be of equal or greater value than the property sold. So if Joe Investor sells his apartment building for $500,000 and has $200,000 in proceeds that he deposits with a Qualified Intermediary, Joe must spend at least $500,000 on the next investment property he purchases if he plans to complete a valid 1031 exchange. If he spends less, he will have to pay taxes on the difference between $500,000 (his sales price) and the price of the new property he is acquires.

6) Contrary to popular belief, a 1031 exchange is not a way to avoid taxes. Rather, it is a way to DEFER taxes. So while you increase your buying power now, someday you will end up paying all of the capital gains tax you avoided along the way. That can be a hefty chunk of money that becomes due all at once. Additionally, if the capital gains tax rate increases over time, you could end up paying more taxes in the future than you would have if you had paid the tax along the way.

Unfortunately, that’s not all; this article is just a very basic overview. The 1031 rules are very complex and each situation requires individual attention. The smallest mistake can cause your 1031 exchange to fail, making you liable for the capital gains tax you thought you didn’t have to pay this year.