A 1031 Exchange is a valuable tax saving strategy for owners of investment or business-use property provided that they follow a few simple rules. With proper planning, a 1031 exchange can also offer benefits beyond tax savings.
WHAT IS A 1031 EXCHANGE?
1031 Exchange is a reference to Internal Revenue Code 1031 (IRC 1031), which allows investment or business property owners to defer paying potentially large tax levies in capital gains and recaptured depreciation associated with real estate sales. These transactions are commonly called tax-deferred “Starker” exchanges, or “like-kind” exchanges and apply to nearly any investment property.
Pursuant to §1031 (a)(1): No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.
Simplified, this means that if you sell a piece of property used for investment or business purposes and purchase property for investment or business purposes, you can defer the taxes that would have otherwise have been due.
When performing an exchange, the regulations require sellers of investment or businss-use property to involve a Qualified Intermediary (QI) to facilitate the exchange. Compliance with IRS regulations governing 1031 exchanges is critical. You must understand the terms and consult professionals who are experts in these transactions.
WHAT IS THE PURPOSE OF A 1031 EXCHANGE?
The purpose of a 1031 exchange is to provide investors with an opportunity to defer capital gain taxation, as well as possibly deferring depreciation recapture, state taxes and the Net Investment Income Tax. It is important to note that the tax obligation is deferred. This means that if a taxpayer sells a relinquished property without a subsequent exchange, the taxpayer will be liable to pay taxes on all of their accumulated capital gains. However, should the taxpayer continue to complete an exchange on each sale until passing, their heirs will inherit the property at the current market value. In other words, they will receive a stepped up basis in the property and the deferred gains are eliminated upon the passing of the taxpayer.
HOW DO 1031 EXCHANGES WORK?
When a taxpayer sells property, the sale would be subject to capital gains tax, in addition to any applicable state taxes, depreciation recapture and Net Investment Income tax. If there is a way to avoid paying those taxes, taxpayers are interested. A 1031 Exchange allows an investor to defer paying capital gains tax on the sale of investment or business property as long as they re-invest into like-kind property of equal or greater value.
How to calculate capital gains tax:
1) Take the purchase price of your property and add the cost of any improvements. For example, an investor who owns a building worth $300,000 and they spent $30,000 on capital improvements the basis goes up to $330,000.
2) Subtract the depreciation price of your property from the amount calculated above (purchase price + capital improvements). To continue the example from above, the investor’s original purchase price was $300,000 and they spent $30,000 on capital improvements for a total of $330,000. Let’s say the property depreciation was $30,000. You would subtract $30,000 from $330,000 for a total of $300,000.
3) Take your sale price and adjust for sale expenses like commissions, legal fees, closing costs. Ex. If your property sells for $400,000 and you subtract closing costs of $25,000, your adjusted sale price would be $375,000.
4) Subtract your basis from the adjusted sale price (to make this easier, use our our capital gains calculator)
TERMS TO KNOW IN A 1031 EXCHANGE
|Exchangor||the taxpayer who is performing a 1031 exchange|
|Seller||the person who owns the property the exchangor wishes to acquire as replacement property|
|Buyer||the person who wants to purchase the property the exchangor is selling|
|Relinquished Property||the property the exchangor wants to sell via the 1031 exchange|
|Replacement Property||the property the exchangor wants to acquire|
|Qualified Intermediary||independent 3rd party required by the IRS that acts as the middleman in the sale and purchase of property in the exchange|
WHAT ARE THE RULES OF A 1031 EXCHANGE?
When contemplating a 1031 exchange, it is important to understand the rules and restrictions involved. There are 5 main rules or facts that taxpayers should be aware of:
1. Net Selling Price – To defer all tax, investors must purchase a property/properties of equal or greater value than the net selling price (NSP) of the relinquished property. NSP = Contract price – title fees and realtor commissions. If replacement properties are less than the NSP, you will be taxed on the difference.
2. Investment or business use property – The property must be held for business/investment use. Investors may not exchange primary or secondary homes. All other real estate qualifies. Sale property and property for purchase both require deeds (i.e., sell deed and purchase deed).
3. 180 day exchange deadline – Investors have 180 days to complete the exchange and must close on all intended purchases by the earlier of the follwoing events:
a. Within 180 days of closing on the sale of your property
b. OR on the due date of the tax return (including extensions)
4. 45 day replacement property identification deadline – Within the first 45 days of the 180 day period, investors must identify up to three possible replacement properties. Only these properties qualify for the exchange. Restrictions apply to investors who wish to identify more than three properties.
5. Qualified Intermediary – Investors must use a QI to facilitate exchanges.
A PICTURE PERFECT 1031 EXCHANGE
AJ Smith owned a one bedroom rental condo in a complex maintained by a management association. He wanted to upgrade to a three bedroom unit. AJ sold his rental condo for $250,000 and bought a larger condo for $475,000. The mortgage on the relinquished property was $80,000 and the mortgage on the purchased property was $305,000. The $170,000 equity in the sold property was rolled into the purchase. This exchange worked well. AJ rolled existing equity into a larger and more valuable unit. The only costs incurred were transaction fees (state transfer taxes, commissions), but the tax savings through the exchange more than offset those costs.
Why was this exchange picture perfect?
1. The Investor purchased a property of equal or greater value to the property sold.
2. The debt on the new property was equal to or greater than the debt on the sold property.
3. The same amount of equity remained in the investment.
WHAT ARE THE STEPS TO A 1031 EXCHANGE?
1. You go under contract to sell your existing property. The contract for the sale should reference that this will be part of a 1031 exchange. Here is some sample verbiage that you can use: Buyer understands that this transaction is one part of a tax‐deferred exchange as recognized under Internal Revenue Code Section 1031 and Buyer agrees to cooperate with Seller regarding this Exchange. There will be no additional cost to Buyer and no delay to closing.
2. You forward a copy of the contract and the contact information of the title company handling the sale to Midland 1031.
3. We prepare the 1031 exchange documents for you to review and sign, as well as closing instructions for the title company or attorney handling the closing for your sale.
4. Prior to closing on your sale, the title company or attorney will forward a copy of the settlement statement to us for review to ensure that everything has been done according to our instructions.
5. On the day of closing, the title company wires the proceeds directly to Midland 1031. (Remember: an important rule of the exchange is that you cannot have possession of the proceeds). The sale proceeds are deposited into a separate escrow account under your name. The funds will be held in that account until the time comes for you to close on your replacement property.
6. You have 180 days from closing on your sale to close on all intended purchases. Within the first 45 days, we must have your written identification of any possible purchases that you intend to make. (We provide a form for you to complete). You can identify up to 3 properties of any value. If you decide to identify more than 3 properties, the total sum of those identified properties cannot exceed 200% of the value of the relinquished property. For example, if you sold for $100,000.00 and you identify 4 possible replacement properties, their total value cannot exceed $200,000.00.
7. Once you are under contract for your purchase(s), we will need a copy of the contract(s) and the contact information of the title company(s) or attorney handling the closing so that we can prepare the remaining exchange documents for you to sign and closing instructions for the title company or attorney. The contract for the purchase should reference that it will be part of a 1031 exchange. Here is some sample verbiage: Buyer intends to do a Tax Deferred Exchange as recognized under Internal Revenue Code Section 1031. Seller agrees to cooperate with the Buyer regarding this Exchange. There will be no additional cost to the Seller, and no delay to closing.
8. Once it is time to close on your purchase, we will review and sign a copy of the settlement statement. Once you have approved and signed the settlement statement, we will wire the 1031 proceeds to the title company.
9. Once you close on all intended purchases, your exchange is complete.
HOW DO I GET STARTED WITH A 1031 EXCHANGE AT MIDLAND?
Our goal is to make it as simple as possible all the way through. The best way to start is to fill out our online form and include a copy of your contract which can be uploaded on that same page or emailed separated.
When we receive that information, we will call or email you with the next steps. It really is that easy!
BENEFITS OF A 1031 EXCHANGE
Defer and possibly eliminate federal and state taxes:
Qualifying real estate incurs no federal (in most cases), state, capital gains, or income taxes on the sale of the property. Click here to see a list of taxes normally levied on real estate sales. These taxes include alternative minimum tax and depreciation recapture taxes.
The tax dollars saved in an exchange are used towards the purchase of investment real estate.
Example: An investor sells their investment property for $500,000, basis is $250,000, the property has been held as an investment property for at least 12 months and assuming that the total capital gain tax is $65,000.
Result: By completing a 1031 exchange, the investor is able to defer the capital gain tax and purchase a replacement property worth $325,000 more than an investor who sells and reinvests with after-tax dollars.
Essentially, a properly executed 1031 exchange can be considered as an interest-free loan from the IRS, in which, the principal may be increased through subsequent exchanges and that may never require repayment. If you are interested in calculating your capital gains, check out our capital gains calculator.
Benefits to a 1031 Exchange other than Tax Deferral
Aside from deferring capital gains, depreciation recapture tax, healthcare and state taxes, there are also non-tax benefits of completing a 1031 exchange.
- Increased Income – You acquire the ability to build more wealth by not having to pay up to 25% in taxes of your hard-earned gains.
- Leverage – You acquire the opportunity to reinvest the federal capital gains and put that money to work for yourself.
- Buying Power – By deferring taxes, investors/exchangors acquire additional equity to reinvest.
- Selling Power – Exchangors do not have to inflate the selling price to cover capital gains that would normally be due upon the sale of investment property, allowing flexibility in assigning a competitive selling price.
- Growth Effect – Investors can perform exchange after exchange, the tax liability of which is forgiven upon the death of the investor. Heirs receive the property based on the current market value of the property at the time they inherit it.
Additional Benefits include:
1. Increased depreciation deduction
2. Eliminate or create joint ownership
3. Construct improvements on a property
4. Greater Income Potential – Exchangors can sell raw land and acquire income producing property, such as a building with rentable units.
5. Change Property Types – 1031 exchanges allow you to exchange into different types of investment real estate such as land to residential, or residential to commercial.
6. Relocation/Move Markets – Exchange your current investment property into a property in a different state.
7. Consolidation – Owners of multiple properties can exchange them for one property that is easier to manage and potentially more profitable.
8. Reduce Management Obligations – You can exchange out of a property that requires extensive management and into a property that is easier to manage, such as land.
1031 EXCHANGE MISCONCEPTIONS
1. You have to “swap” properties with the same individual.
While this was a requirement of the original IRC 1031, the IRS now allows one to sell property to someone totally unrelated to the person from whom they are purchasing the replacement property.
2. Only investors of large commercial properties are eligible for exchanges.
This is not true. 1031 exchanges apply to all investment properties, large and small. It works the same way for a corporation selling a large shopping center as it does for an individual selling a vacation rental property.
3. You have to buy something that costs more than you are selling.
This is only true if you want to defer all of the capital gain taxes. You are able to purchase for less and still have some tax benefits, but you may also incur tax liability on the difference in values.
4. You can only exchange into the same type of property as the one you are selling.
Untrue. All real estate qualifies for a 1031 exchange. You can sell a vacant lot and exchange into a residential property or vice versa. You are unable to exchange your primary and secondary residences but the other exchange possibilities are virtually endless provided the property is used for business or investment purposes.
5. You will have to pay taxes sooner or later, so why bother with an exchange?
This is not necessarily true. By carefully planning and properly executing 1031 exchanges, you can avoid ever paying taxes. Read about two ways that you can do a 1031 exchange and potentially NEVER pay taxes.
6. A 1031 Exhcange is complicated and not worth the trouble.
Also untrue. When you work with a competent QI, the process is simple. The QI will ensure you are aware of deadlines and that the transaction is performed in compliance with IRS regulations.
TIPS AND REMINDERS
We have outlined all the information you need to know to become more familiar with the 1031 exchange process. You are not expected to be an expert; that’s Midland 1031’s job! We just want you to have a better understanding so you can make informed decisions.
Here are some key things to keep in mind when considering a 1031 exchange:
1. The exchange must be set up BEFORE the first closing. For example, for a standard delayed exchange, the exchange must be set up prior to closing on the sale of the relinquished property. Once you leave the closing, the opportunity to do the exchange is lost. It is never too early to start the process. While we can do exchanges at the last minute, having everything in place in advance makes it easier on all parties handling the transaction.
2. In order to have a fully tax-deferred exchange, you must purchase replacement property that is at least equal to or greater than the relinquished property sale price.
3. There must be continuity of taxpayer. In other words, the taxpayer that sells is the taxpayer that must acquire the replacement property.
4. The property you are selling and eventually purchasing must be investment or business use property.
5. Consult with a CPA or tax advisor. They know better than anyone whether or not an exchange is the best choice for you. Qualified intermediaries cannot provide any legal or tax advice. Our role is to facilitate the exchange. Therefore, it is important you keep all necessary members of your financial team in the loop. Follow these tips to ensure a smooth exchange.
1. What are state to state differences in a 1031 exchange?
Several states have no income tax so it is not necessary to report the exchange in these states while other states do follow the federal tax code and allow the deferral of the state taxes. Pennsylvania does not recognize 1031 exchanges so you will have to pay state income taxes.
In many states, there is a mandatory non-resident withholding tax that must be paid when the property is transferred, however, if you are doing a 1031 exchange it may be possible to obtain an exemption. In many cases this needs to be done prior to selling the relinquished property. Some of these states are: California, Georgia, Colorado, Hawaii, Maine, Maryland, Mississippi, New York, West Virginia, Vermont, South Carolina, Oregon, Rhode Island, North Carolina and New Jersey.
2. Can I avoid paying taxes forever?
Yes. Simply follow 1031 exchange rules everytime you sell one or more properties and buy replacement properties. Upon passing, your estate forever escapes all capital gain taxes.
3. Can I get money out of the exchange tax free?
Yes, Complete your exchange first and after closing there is the opportunity to refinance the new property. It is critical that you wait until the exchange is complete before you begin the process of refinancing.
4. Can I hold a partial loan on the property I am seling and still have a tax-free exchange?
Yes. If payments come to you, they are taxed as you receive them, on an installment sale basis. The balance of your equity is exchanged tax free. If you want the loan to be part of the exchange, determine this prior to closing as the loan has to be payable to the QI. You must ensure the loan is paid in full within 180 days and prior to closing on your replacement property if you want those funds to be part of the exchange. Any portion not paid within 180 days is not considered part of the 1031 exchange and is subject to tax.
5. Can I pay for my 1031 exchange out of my sales proceeds?
Yes. Your exchange fees can be paid out of relinquished property proceeds.
6. If I close on my relinquished property without a QI can I still do a 1031 exchange?
No. You must hire a QI in advance of closing on the relinquished property.
HOW DO I CHOOSE A QUALIFIED INTERMEDIARY (QI)
When choosing a QI, it’s important to do your due diligence. Ask questions such as:
• What is the QI’s background?
• Does anyone on staff have their CES (Certified Exchange Specialist) designation?
• How long has the QI been in business?
• Is the QI bonded and insured?
• How does the QI ensure your funds are protected?
Midland is a highly respected company in the world of exchangors. We are the gold-standard in service, value, and knowledge. We look forward to helping answer your questions before you start, jump in when you are ready to get started, and we stick with you all the way through closing.
This summary page also gives Midland’s background in the 1031 Exchange arena.
Here are some resources for some of the behind-the-scenes forms and publications supporting 1031 exchanges.
• IRS Form 8824 – IRS form for reporting like kind exchanges https://www.irs.gov/pub/irs-pdf/f8824.pdf
• IRS Form 4797 – IRS form for sales of business property
• IRS Schedule E (Form 1040) – IRS forms for reporting supplemental income and loss
IRS Foreign Investment in Real Property Tax Act (FIRPTA) forms:
• IRS Publication 515 https://www.irs.gov/pub/irs-pdf/p515.pdf
• IRS Form W-7 https://www.irs.gov/pub/irs-pdf/fw7.pdf
• IRS Form SS-4 https://www.irs.gov/pub/irs-pdf/fss4.pdf
• IRS Form 8288-B https://www.irs.gov/pub/irs-pdf/f8288b.pdf