It has been said that the only things certain in life are death and taxes. Real estate investors cannot cheat death. However, they can defer taxes on the gains from the sale of their real estate using Section 1031 of the Internal Revenue Code. Section 1031 allows deferral of taxes on the disposition of real estate held for investment or business purposes, as long as that real estate is exchanged for another “like-kind” property (commonly referred to as “(1031 exchanges”).
Under Section 1031, all real estate is considered “like-kind,” so the real estate asset classes of the two properties that are exchanged doesn’t matter. What matters is that both properties be used in a trade or business or held for investment. For instance, an apartment building investment is considered “like-kind” with a piece of farmland used in a farming business or even an investment in a long-term ground lease for an office building (as long as there are at least 30 years left on the lease).
Most 1031 exchanges are done through what are called “forward exchanges” instead of a simultaneous exchange of two properties. In a forward exchange, the taxpayer sells one real estate investment (called the “relinquished property”) and then later invests the proceeds from the sale in another real estate investment (called the “replacement property”).
In a forward exchange, the proceeds from the sale of the relinquished property are deposited with a third-party “qualified intermediary” (called a QI) until they are used to acquire the replacement property. The QI assists the taxpayer with the mechanics of the exchange and helps to assure that the exchange is done property.
In addition to using a QI, there are timing requirements for a forward exchange:
Identify within 45 calendar days. The taxpayer must identify the replacement property within 45 calendar days of sale of the relinquished property. This identification needs to be made in writing to the qualified intermediary.
Acquire within 180 calendar days. The taxpayer must acquire the replacement property within 180 calendar days following the sale of the relinquished property.
Acquire before the tax return due date. The taxpayer must acquire the replacement property before the due date for the taxpayer’s tax return for the year in which the relinquished property was sold. This isn’t a problem for individual taxpayers unless the relinquished property is sold after October 17 in a calendar year. Taxpayers should watch this deadline, however, and obtain extensions of the filing deadline for their tax returns if necessary. Taxpayers who are not individuals should work with their qualified intermediaries and tax preparers to be sure they comply with this deadline.
Taxpayers are allowed to identify more than one replacement property for each relinquished property. The taxpayer may choose to do this either to diversify the taxpayer’s real estate investment or to provide back-up alternatives if the first-choice relinquished property is not acquired for one reason or another. There are three options for identifying replacement properties:
Three-property rule. The taxpayer can identify up to three potential replacement properties without regard to their value.
200% rule. The taxpayer can identify an unlimited number of replacement properties, BUT the aggregate fair market value (FMV) of the identified replacement properties can’t be more than 200% of the net sales value of the relinquished property. For example, if a relinquished property netted a $500,000 FMV, the taxpayer could identify any number of replacement properties, but their total FMV couldn’t be more than $1,000,000 (i.e. 200% of $500,000).
95% identification rule. The taxpayer can identify an unlimited number of replacement properties without limit to the aggregate FMV of the properties, BUT the taxpayer must acquire properties totaling at least 95% of the aggregate value identified. For example, a taxpayer whose relinquished property netted $500,000 in FMV could identify twenty replacement properties totaling $10,000,000 in FMV, PROVIDED that the taxpayer acquired $9,500,000 in FMV of those properties. Needless to say, this rule isn’t used frequently, because it may require the taxpayer to put additional cash into the real estate investments. However, it can be a tool for real estate investors who are in the process of building their portfolios and have available cash.
This is just a basic outline of the 1031 exchange requirements. It shouldn’t be considered legal advice for any taxpayer. The 1031 exchange rules are complicated and can vary depending on the individual taxpayer’s situation, so it’s important that real estate investors to consult a tax advisor experienced with 1031 exchanges. It’s also important to line up a qualified intermediary well before selling the relinquished property. With careful planning and sound legal and tax advice, real estate investors may be able to build their portfolios without paying substantial capital gains taxes.