1031 Exchanges – What are they and how can they help me defer taxes on my property sale?

Dan Wilson

November 2022 – In the world of real estate sales, both residential and commercial, many savvy property owners have utilized a strategy to defer capital gains tax on real property through the use of a “Like Kind” Exchange, or 1031 Exchange (named after Internal Revenue Code Section 1031*). While I am not a tax expert and you should consult your tax professional (CPA or Tax Attorney) before taking any action, the below information is meant to provide the basics of an effective tool to defer taxes and potentially grow equity in real property over time. There are many nuances and important technical aspects of a 1031 exchange that should be discussed thoroughly with your tax professional, or else you may be subject to taxation, penalties or awkward conversations with IRS agents during an audit (nobody wants that!)

A “Like Kind Exchange”, or 1031 exchange, is defined by the IRS as “when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or “like-kind”. In the case of real estate, properties are of “like kind” if they’re of the same nature and character, even if they differ in grade or quality, regardless of whether they’re improved or unimproved. Almost all real estate qualifies for an exchange, with the exception of one’s primary residence. For example, if one owned a Four-unit multifamily apartment building and wanted to perform a like-kind exchange into an office building, that would be fine.

1031 Exchange Example

To illustrate the basics of a 1031 exchange, a simple example can help show the benefits compared to an after-tax traditional property sale

An investor sells property (with no debt) for $1,000,000. The property has been fully depreciated and has a cost basis of $100,000. The property has been held for >12 months, so long-term capital gains is applicable, and we will assume a combined tax rate of 25% for simplicity (federal capital gain, depreciation recapture, net investment income tax and state).**

As you can see, this deferred tax(es) is meaningful, and can grow over time as the Replacement Property(ies) grows in value.

Note: Disclose, disclose, DISCLOSE! Whether you are a buyer or seller in a planned 1031 exchange, it is crucial to advise any potential counterparty that you are seeking to achieve a 1031 exchange and seek their assistance in doing so. In any exchange, it is critical to work through a “Qualified Intermediary”, who will facilitate the transaction according to IRS code, and also help guide the parties towards a successful exchange outcome.

THE BASICS

While there are many subtle nuances and variations related to a 1031 exchange, there are some basic requirements and rules of the transaction that are straightforward.

  • Purchase Replacement Property at equal or greater value to the Relinquished Property
  • Reinvest all of the equity in the Replacement Property
  • Obtain equal or greater debt on Replacement Property (exception: a reduction in debt can be offset with additional cash from exchanger, but increasing debt cannot offset a reduction in exchange equity)

The key timelines for a 1031 exchange are:

  • 45 Days Identification Period – From the date of sale of the Relinquished Property, the exchanger has 45 days to provide written identification of Replacement Property options. This can be one property, or multiple, but the rules above apply pertaining to equal/greater (total) value and equity used
  • 180 Days Closing Period – From the date of sale of the Relinquished Property, the exchanger has up to 180 days to close on the Replacement Property(ies)

If you are interested in exploring a 1031 exchange, please reach out to us and we can talk it over and get all your questions answered!

Sources: * https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips
** “Exchange Highlights Brochure” Investment Property Exchange Services, Inc. (IPX1031), a Fidelity National Financial Company
First Capital Property Group, Inc. is a Full-Service Real Estate company leasing and managing over 2 million square feet of commercial property in Central Florida. The information contained herein is believed to be reliable; however, First Capital makes no representations or warranties, expressed or implied, regarding its accuracy. ©2022 First Capital Property Group, Inc. – Licensed Real Estate Brokers.