1031 Exchanges Explained in Plain English

The sale of investment real estate, be it commercial, industrial or residential is subject to the provisions of the Internal Revenue Service tax code.

Upon the sale of a real estate at a gain, be it short term or long term, the seller is obligated to pay a tax which, depending on the size of the gain, may be substantial.

However, there is a section of the tax code that allows real estate investors to implement a strategy to avoid paying taxes upon the sale of investment property.

Investors are allowed to defer paying taxes on their gains until sometime in the future provided they comply with certain rules contained in the Section 1031 of the tax code.

Those rules involve the exchange of properties; hence, the strategy is commonly known in the real estate industry as a 1031 exchange.

Section 1031

Section 1031 allows investors to retain all the proceeds from a sale provided those proceeds are reinvested in "like kind" real estate. 

An investor does not avoid ever having to pay taxes on his gains, but he is able to accomplish the next best thing which is to defer paying the tax until a later date. 

Investors can execute any number of 1031 exchanges over and over.  There are no restrictions regarding the number of transactions or the frequency of transactions.

Investors can swap out of one property and into another many times over.  

While one may have a gain on every swap, there is no tax due until the process is discontinued and the investor receives cash for a sale. 

When that happens the investor pays only one long-term capital gains tax.  

In essence, the government is allowing you to use their money to accumulate wealth in real estate for as long as you execute 1031 exchanges.

Section 1031 contains strict rules that an investor should be aware of prior to attempting the execute an exchange.

If the investor meets all the rules at the time of the exchange, there will be no due or possibly a limited tax due when the exchange is executed.

But failure to adhere to the rules will result in an invalid exchange.

What Are the Rules of a 1031 Exchange?

Rule 1: "Like Kind Exchange"

The first rule of a 1031 exchange is misleading – an exchange must be "like kind." 

This would seem to mean that if an investor sold an apartment building he must purchase another apartment building.

However, this is not the case.

For 1031 purposes, "like kind" does not mean "like kind." 

Under 1031, an investor can sell an apartment building and purchase a vineyard. 

Raw land can be sold and the proceeds can used to buy a farm or a ranch.  

In short, investors have considerable flexibility in choosing a replacement property.

Almost any kind of real estate can be swapped for any other kind of real estate.  

Keep in mind the advantages inherent in a 1031 exchange are available only for investment properties.  

A primary residence does not qualify, nor does a second home. 

Also, an individual who buys houses, fixes them up and sells them cannot execute a 1031 exchange.  

In addition, 1031 rules require that both the property being sold and the one being acquired must be located in the United States.

Rule 2: The Value of the Replacement Property

The second rule of a 1031 exchange concerns the value of the investors replacement property.

If the property being acquired is of equal or greater value than the value of the property being sold, an investor will not be liable for taxes.

Also, the value of the replacement property can be allocated to more than one property.  

For example, if an investor sold a strip mall for $2,000,000 he would then purchase other "like kind" investment property of equal or greater value.

That could be another strip mall worth at least $2,000,000.

Or a ranch worth $500,000 and two apartment buildings each worth $750,000.  

In addition, escrow fees, broker commissions and appraisal fees are considered part of the acquisition cost. 

In calculating replacement value the project gained by an investor is not a factor in calculating replacement value.

If an investor purchased a building for $150,000 and later sold it for $400,000, the $250,000 gain is irrelevant.

The investor must only concern themselves with the $400,000 sale price.

In the event the investor decides to purchase another investment property for $300,000, they will have to pay capital gains tax on the $100,000 shortfall.

The $100,000 is known in the real estate industry as "boot."

Rule 3: The 45 Day Rule

Once an investor has sold their property they have 45 days to inform an intermediary in writing as to the specific replacement property they plan to acquire.

If an investor fails to identify a property within 45 days, the 1031 exchange becomes invalid. 

Since 45 days is a relatively short time in which to locate a replacement property it would be foolish for an investor to wait until the sale of the property before searching for something to trade into.

In order to create a comfortable cushion of time in which to locate a target property, it is wise to start the search the same day on which your existing property is listed for sale.

In all likelihood your property will be on the market for a number of months before closing, giving you sufficient time to locate the new property.

However, depending on market conditions, it may be wise to find a new replacement property to purchase before listing your existing property.  

If that's not possible and you are having difficulty finding a replacement property, you can allow yourself more time by negotiating an extension of the escrow period on the property you are selling.

Besides the fact that an investor must find a replacement property within 45 days after the sale of this property there are additional provisions one must abide by.  

One of them involves identifying potential acquisitions. 

It is wise to identify more than one potential acquisition.  

If an investor identifies only one property and problems arise during the due diligence period it could jeopardize the entire exchange process.

For that reason, the IRS allows investors to identify three potential acquisitions. 

Thus, if your first choice falls through you have two other properties lined up as replacements. 

It is possible to designate more than three properties for purchase. 

However, if that happens, certain rules must be followed.  

If more than three properties are identified an investor is obligated to buy 95% of them.

An alternative to the 95% rule is the 200% rule.  

The 200% rule allows an investor multiple properties, provided their combined total cost is less than 200% of the price obtained for the original property.

Suppose for example an investor designates ten properties as replacements. 

Either they would be obligated to purchase 95% of them or else the total value of all 10 properties must be less than 200% of the value of his original property.

If the original property is sold for $800,000 the total value of the 10 designated properties would have to be less than $1,600,000.

Designating a property for purchase must follow strict guidelines. 

There must be a written communication signed by the investor and presented to either the seller of the property to be acquired or to the intermediary.

Delivery of the notice to your real estate broker, your CPA or your attorney is deemed unacceptable according to the IRS. 

Rule 4: The 180 Day Rule

As mentioned previously, in a 1031 exchange, the sale of the original property triggers the start of a clock counting down 45 days in which to designate a replacement property. 

Simultaneously another clock starts ticking. 

Concurrent with the 45 day countdown is a 180 day countdown. 

The investor has 180 days from the closing on their original property to close on their replacement property. 

It is important to remember that the 45 day time period and the 180 day time period run concurrently.

The investor who takes the full 45 days to identify a replacement property now has only 135 days in which to close the transaction, not 180 days.

IRS regulations state the title to the replacement property must be officially transferred by the end of 180 days. 

Non-compliance with either the 45 day rule or the 180 day rule will cause the 1031 exchange to fail. 

Both rules are strictly enforced.

Rule 5: The Use of an Intermediary

Rule #5 of 1031 exchanges deals with the use of an intermediary. 

Sometimes the intermediary is called an accommodator. 

In a perfect world an investor would trade their property for a property owned by another investor. 

However, the world is not perfect and the odds of two investors wanting to acquire each other's property are remote.

As a result, most 1031 exchanges are delayed exchanges and involve the use of a qualified intermediary. 

The intermediary deposits the proceeds from the sale of the original property into an escrow account.  

The intermediary uses the escrow funds to purchase the replacement property on behalf of the investor.  

The intermediary must be an independent third party.

It is not acceptable for an investor to use his real estate agent, investment banker, business associate, bank officer, spouse, employee of his company or anyone else who operates under his discretion. 

Any individual who has occupied one of these positions during the previous two years is also ineligible.  

It is very important the investor not receive any of the escrow money or exit the exchange agreement prior to the time the intermediary has set for the transfer of property and the payment of funds.

Choosing a qualified, well-established intermediary is of primary importance.  

Investors should select someone who has been in the business for many years and is known to have the highest ethical standards.  

Otherwise, the exchange investor runs the risk of having their escrow funds stolen or misappropriated by a dishonest intermediary.

How Does a 1031 Exchange Work: The 8 Basic Steps

A 1031 exchange begins with an investor deciding to exchange a property they own for a property they plan to acquire. 

Their decision to execute a 1031 exchange should be made only after careful consideration of the rules and costs of an exchange versus paying the tax due upon the sale of the property.

Once the investor has decided to go forward there are 8 steps in the process.

Step 1: List Your Current Property

List your current property in the usual manner with two exceptions.

First, your listing should clearly state your intention to do a 1031 exchange.

Second, your listing should emphasize the need for cooperation on the part of the buyer in executing the exchange.

Step 2: Start the Search for a Replacement Property

Since you only have 45 days after your property has been sold to find a replacement property it is wise to start looking even before listing your property.

Step 3: Accept an Offer on Your Property

When you accept an offer on your property be sure that your acceptance emphasizes your intention to do a 1031 exchange and that you require cooperation from the buyer.

Step 4: Hire an Intermediary

When you hire an intermediary make sure they have an impeccable reputation. 

Step 5: Close on Original Property

The title company and your intermediary will facilitate the close of the sale of your original property. 

All funds will be deposited into a bank account controlled by the intermediary. 

Step 6: Identify Replacement Property

Identify up to three properties. If you identify more than three, remember the 95% and 200% rules above.

Step 7: Enter a Contract on the Replacement Property

Make sure the seller is aware you are acquiring his property via a 1031 exchange. 

To be safe, enter into two other properties on a contingency basis.

Step 8: Close on the New Property

This is a simple process in which your intermediary disburses funds to the title company.