How 1031 Exchanges Work

The title 1031 Exchange comes from the 1031 section of the IRS tax code. The idea behind a 1031 exchange is that an investor does not owe taxes when he or she sells an investment property as long as the money remains in a like-kind investment or business. There are several versions of the 1031 exchange that would take a full book to cover in detail. All versions have one common advantage – complete deferral of capital gain and depreciation recapture taxes. There is no limit to the number of times that property can be exchanged. Through 1031 exchanges, you can continuously step up the quality and value of your real estate holdings without paying capital gains taxes during your lifetime.

There is no set amount of time that a property must be owned to qualify for a 1031 exchange. However, dealer status becomes an issue when it appears the property is inventory for sale (flipping property) rather than held for investment or business purposes. Property held as inventory for sale does not qualify for a 1031 exchange. Take for example a property acquired in an exchange and turned over for another property a year later. This property can be characterized as inventory if there is not an adequate underlying reason for the second exchange. A good reason for the short-term exchange would be that the investor transferred unexpectedly to a job in another state and wants to have the investment property near enough for hands-on management and maintenance.

Many real estate professionals are aware of and have participated in exchanges. The profession of Qualified Accommodators developed exclusively to support delayed 1031 exchanges after the Starker court case determined 1031 exchanges did not have to occur simultaneously. Today, many more people outside of the real estate industry are becoming familiar with 1031 exchanges.

A Little History

The word “exchange” represents the concept that a taxpayer is not selling the initial investment but rather exchanging it for a like-kind investment. Section 1031 was originally added to the tax code in 1921. Until the Starker court case was settled in 1979, the exchange of one investment property for another had to occur simultaneously to be tax-free. This required that two parties willing to exchange properties needed to find each other - it rarely happened. In 1984, section 1031 was revised to allow time delayed exchanges. The delayed exchange enabled a person to first sell a property and then find replacement property. The introduction of the delayed exchange made this a much more manageable process, resulting in a rapid increase in its use for deferring taxes.

Declaring to Exchange

In the delayed 1031 exchange, the businessperson or investor formally declares the intention to exchange. A qualified accommodator plays a critical role at the center of the exchange. This critical role is to assure that the taxpayer does not gain constructive control of the money or other benefits from the sale. All financial benefits must transfer to the new property if taxes are going to be completely deferred.

The sale agreements for both the relinquished property and acquired property need to include clauses that a 1031 exchange will be conducted. The purchaser of your relinquished property and seller of the property you are acquiring do not have to be conducting an exchange themselves. However, they need to agree to cooperate with your exchange.

Timing Requirements

Within 45 days of escrow closing on the sold property, the replacement property must be formally identified. More than one possible replacement property can be identified. There are three formulas for identifying replacement property. One is directly identifying any three potential replacement properties without regard to the price of the properties.

Another method is the 200% rule. This rule allows identification of an unlimited number of properties as long as the total of all the prices is not more than twice the price of the property sold. This method makes sense if you are exchanging into multiple properties instead of a single replacement property. For instance, you sell an urban office building worth a few million dollars and intend to reinvest the money into several residential houses. The 200% rule allows you to identify a larger number of possible replacement properties. However, the 200% rule does not work well if you are exchanging a single property for another single property. In that situation, the 200% limit allows identification of only two properties at best. Most likely, only one property can be identified if the purchase price exceeds what you received for the relinquished property.

An alternative method is identification of an unlimited number of properties regardless of their fair market value. At least 95% of the fair market value of these properties must be acquired (the 95% rule).

Once the replacement property is identified (within 45 days), you must close escrow on the replacement property within 180 days of the date escrow closed on the relinquished property.

This is a very simplified version of a complicate portion to the IRS code. If you've never completed a 1031 Exchange, you'll want professional help.

Please leave a comment if this article was helpful or if you have a question.

Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for seven years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. In the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.