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1031 Exchange

On April 25, 1991, the IRS introduced deferred exchange regulation Reg 1.1031(k)-1. This provision allows taxpayers to defer all capital gains taxes from the sale of investment property, provided they work with a Qualified Intermediary, adhere to IRS guidelines, and reinvest the proceeds into more suitable investment property within 180 days of the sale’s closing. Essentially, this enables you to reinvest funds that would otherwise go toward capital gains taxes into additional investment properties, helping you generate more income. This exchange can occur across all types of real property within the United States. Our dedicated service team is here to make the 1031 exchange process as simple and effective as possible. Below is a straightforward example of the potential impact (excluding state taxes):

Selling Property without 1031 Selling Property with 1031
Sale Price: $750,000 $750,000
Less your Mortgage: $450,000 $450,000
Equity: $300,000 $300,000
Cost Basis: $250,000 $250,000
Taxable Gain: $500,000 $500,000
Tax Rate (Base Federal Capital Gain): 20% N/A
Taxes Due: $100,000 $0
Left For Investment: $200,000 $300,000
Total Savings: $0 $100,000

This is why the 1031 Tax-Deferred Exchange is often referred to as “The Best Tax Loophole Left.” When it’s time to sell your replacement property, you can use the 1031 tax deferral once more. This strategy can multiply your tax savings significantly. It allows you to acquire larger and more profitable replacement properties, increasing your income potential. By continuing to exchange and avoiding cashing out, you can build a substantially larger portfolio over time. Assistance with your 1031 Exchange is just a click or phone call away!

The 1031 real estate exchange is often called the Starker 1031 Exchange or Starker Exchange, named after the landmark case where a non-simultaneous exchange was first approved by the court. Initially, the IRS rejected these exchanges, arguing that 1031 real estate exchanges only qualified if all properties involved were transferred simultaneously. According to the IRS, there could be no time gap between the transfer of the relinquished property and the replacement property. However, the Starker family paid their taxes and challenged the IRS by filing lawsuits in the U.S. District Court in Portland, Oregon. This resulted in three court cases, presided over by District Judge Gus Solomon.

Starker 1

The first case, known as Starker I (1975), involved Bruce and Elizabeth Starker. The IRS issued a deficiency notice against them, prompting the Starkers to pay the tax and then sue for a refund. In a brief opinion, the court ruled in favor of Bruce and Elizabeth Starker without addressing the issue of the exchanges not being simultaneous.

Starker II

In 1977, the government pursued a case against T.J. Starker (T.J. Starker v. U.S., 431 F. Supp. 864 D. C. Ore. 1977). The same court that ruled in Starker I now determined that no exchange had occurred and that the transaction was a taxable sale. This decision effectively overturned the earlier ruling. Judge Solomon, who presided over both cases, acknowledged his error in Starker I, stating, “My opinion in Starker I has been given wide publicity. I believe that it is desirable that my opinion in this case be published to prevent the mischief that I believe Starker I has caused.” He concluded that T.J. Starker had exchanged real property for a promise, which did not qualify as like-kind under the statute. Additionally, he ruled that the “growth factor” in the transaction was taxable as interest.

Starker III

The third and final case was T.J. Starker’s appeal (T.J. Starker v. U.S., 602 F.2d 1341, 9th Cir. 1979). The Ninth Circuit Court ruled that the government was collaterally estopped by Starker I from re-litigating nine of the transfers that had been overturned in Starker II. Most significantly for real estate investors, the court found no requirement for simultaneity in the 1031 tax code. The ruling favored Starker, officially establishing the concept of the delayed exchange, which has since become a cornerstone for 1031 tax-deferred exchanges.

The concept of a 1031 Exchange has evolved significantly since its introduction in 1921, when all exchanges had to be simultaneous. Over time, it has expanded to include more complex structures, such as reverse exchanges, and it is likely to continue evolving in the future.

Contact our 1031 Exchange Experts today and start making a little history of your own. Reach out for a free 1031 Exchange consultation and expert assistance!

Haven Exchange is a fully bonded Qualified Intermediary for 1031 Exchanges, dedicated to providing unmatched security and service. With over 11,000 successful exchanges coordinated, our experienced and friendly support team, including CPAs specializing in 1031 Exchanges, is ready to assist you. We’re available weekdays from 9 AM to 5 PM PST to help make your exchange process seamless and efficient.

Introduction

A 1031 exchange is one of the most powerful tax-deferral strategies available to real estate investors. Named after Section 1031 of the Internal Revenue Code, this strategy allows investors to sell a property and reinvest the proceeds into a like-kind property, deferring capital gains taxes. This tax benefit can significantly enhance wealth accumulation, particularly when investing in NNN (Triple Net) properties, which offer stable, passive income.

Understanding how to structure a 1031 exchange properly ensures compliance with IRS regulations and maximizes investment potential. This guide covers the essential rules, guidelines, and best practices for executing a successful 1031 exchange.

What is a 1031 Exchange?

A 1031 exchange allows investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into another like-kind property. Instead of paying taxes immediately, investors can continue growing their real estate portfolio tax-free until they decide to cash out.

Key Benefits of a 1031 Exchange:

  • Tax Deferral: Postpone capital gains tax and depreciation recapture.

  • Portfolio Growth: Reinvest in higher-value properties to build wealth.

  • Estate Planning: Reduce tax liabilities for heirs through a stepped-up basis.

  • Diversification: Shift into NNN properties for more passive income or different real estate sectors.

What Qualifies as "Like-Kind" Property?

In a 1031 exchange, like-kind properties refer to real estate used for business or investment purposes. Examples include:

  • Selling an apartment complex and acquiring a NNN retail property.

  • Exchanging raw land for a commercial building.

  • Swapping a rental home for a shopping center.

Personal-use properties (e.g., primary residences) do not qualify for a 1031 exchange.

A 1031 exchange is a powerful tool for long-term wealth accumulation. Instead of losing money to taxes, investors can reinvest 100% of their profits, leveraging larger properties or higher-yield investments such as NNN properties.

Why Consider NNN Properties?

NNN properties are ideal for 1031 exchanges because they offer:

  • Stable, passive income with tenant responsibility for taxes, insurance, and maintenance.

  • Long-term leases with corporate tenants.

  • Lower risk compared to multi-tenant investments.

By continuously rolling over properties through 1031 exchanges, investors can grow their wealth tax-deferred while enjoying consistent cash flow.

Eligibility Requirements:

  • Both the relinquished and replacement properties must be investment or business properties.

  • The new property must be equal to or greater in value than the old one to fully defer taxes.

  • Investors must follow strict IRS timelines to qualify.

Important Deadlines:

    • 45-Day Identification Period: Identify potential replacement properties within 45 days of selling the original property.

    • 180-Day Exchange Period: Complete the purchase of the replacement property within 180 days of selling the original asset.

Do's:

✅ Work with a Qualified Intermediary (QI): IRS rules require a third-party facilitator to handle the exchange funds.

✅ Follow strict timelines: Ensure compliance with 45-day and 180-day deadlines.

✅ Reinvest all proceeds: To defer 100% of taxes, invest all sale proceeds into the replacement property.

✅ Consider NNN properties: These are excellent exchange options due to predictable returns and minimal management responsibilities.

Don'ts:

❌ Miss the deadlines: Exceeding the 45-day or 180-day limits disqualifies the exchange.

❌ Take possession of funds: Doing so triggers a taxable event.

❌ Exchange personal-use properties: Primary residences do not qualify.

❌ Forget about depreciation recapture: A 1031 exchange can defer, but not eliminate, depreciation recapture taxes.

  1. Sell the Investment Property – Work with a Qualified Intermediary (QI) to handle exchange funds.

  2. Identify a Replacement Property – Submit a list of potential properties within 45 days.

  3. Sign a Purchase Agreement – Negotiate terms with the seller.

  4. Close on the Replacement Property – Complete the transaction within 180 days.

  5. Report the Exchange on IRS Form 8824 – File the necessary tax documents.

Following these steps ensures a smooth and compliant 1031 exchange.

  • 1031 Exchange: A tax-deferred swap of investment properties under Section 1031 of the IRS code.

  • Like-Kind Property: Real estate of similar nature, used for investment or business purposes.

  • Qualified Intermediary (QI): A required third party that facilitates the exchange and holds sale proceeds.

  • Boot: Any cash or personal property received during an exchange, which may be taxable.

  • Reverse Exchange: Buying the replacement property before selling the relinquished property.

  • Depreciation Recapture: Tax owed when selling a property that has been depreciated for tax benefits.

What is a 1031 Exchange

On April 25, 1991, the IRS introduced deferred exchange regulation Reg 1.1031(k)-1.

This regulation allows taxpayers to defer all capital gains taxes from the sale of investment property. To qualify, you must work with a Qualified Intermediary, follow IRS guidelines, and reinvest the proceeds into suitable investment property within 180 days of the sale’s closing.

By deferring capital gains taxes, you can reinvest the money that would otherwise go to taxes into additional investment properties, creating opportunities for greater financial growth. This applies to all types of real property across the United States. Our dedicated service team is here to make the 1031 exchange process as seamless and effective as possible.

The 1031 Tax-Deferred Exchange is often hailed as “The Best Tax Loophole Left.” When you sell a replacement property, you can use the 1031 deferral again, significantly multiplying your tax savings. This strategy enables you to acquire larger, more profitable properties, increasing your income potential. By continuing to exchange and avoiding cashing out, you can achieve extraordinary growth in your investment portfolio. Expert 1031 Exchange assistance is just a click or call away!

In a 1031 Exchange, the entity that starts the exchange must also be the entity that completes it. The Qualified Intermediary will prepare the necessary documentation, ensuring the vesting information is consistent with the title commitment or title report of the relinquished property. The entity that relinquishes the property must be the same entity that acquires the replacement property.

For example:

  • A trustee relinquishes… the trustee acquires.
  • Schmidt LLC relinquishes… Schmidt LLC acquires.
  • Se Bon Partnership relinquishes… Se Bon Partnership acquires.
  • A wife relinquishes… the wife acquires.

The Exchanger’s legal relationship to the relinquished property must remain the same with respect to the replacement property. This means that the entity or person selling the relinquished property must be the same entity or person purchasing the replacement property. Exchangers should anticipate this requirement in advance, as business, liability, and lender considerations could complicate meeting this rule.

For example, if a husband is relying on his wife’s income for financing, the lender may require her to be on the deed. Lenders typically lend to individuals, not trustees, and exchangers who want to use different LLCs for each property may not be able to do so within the exchange structure.

It’s important for the Exchanger to consult with their advisor, attorney, lender, and Qualified Intermediary when structuring the exchange to avoid complications. These issues are easier to address before loan documents are signed. However, certain changes in vesting typically do not invalidate the exchange, including:

  • Changing vesting from a trustee (who is also the trustor) to their individual capacity, as long as the trust doesn’t have a separate tax ID number.
  • If the Exchanger passes away after closing on the relinquished property, the estate may complete the exchange.

The most common type of 1031 exchange is the delayed exchange, which became widely used following the Starker decision in 1979, changes made by Congress in 1984, and the final regulations in 1991. In a delayed exchange, there are strict deadlines that Exchangers must follow to ensure the exchange is completed successfully:

Key Deadlines for a Delayed Exchange:

Exchange Begins: The exchange begins on the earlier of:

  • The date the deed records, or
  • The date possession is transferred to the buyer.

Exchange Ends: The exchange ends on the earlier of:

  • 180 days after the transfer of the relinquished property, or
  • The due date (including extensions) of the Exchanger’s tax return for the year in which the relinquished property is transferred.

Identification Period: The first 45 days of the exchange period, starting from the date the relinquished property is transferred. The Exchanger must either close on the replacement property or formally identify potential replacement properties within this 45-day window.

Exchange Period: The entire exchange period, which is a maximum of 180 days from the transfer of the relinquished property.

Multiple Relinquished Properties: If there are multiple relinquished properties, the deadlines apply to the first property’s transfer date.

Deadlines and Restrictions:

  • No Extensions for Holidays: If a deadline falls on a holiday like Thanksgiving, Christmas, or New Year’s Day, it cannot be extended.
  • Destruction of Identified Property: If identified replacement property is destroyed after the 45-day Identification Period, the Exchanger cannot identify a new property after the 45 days have expired.
  • Mistaken Identification: Mistakenly identifying a property (e.g., identifying condo A when condo B was intended) does not allow changes to the identification after the 45-day period.

The 45-Day Rule for Identification:

  • Identification Deadline: The Exchanger must identify the replacement property in writing within 45 days. This must be done through a formal identification notice (signed and sent to the Qualified Intermediary) that includes an unambiguous description of the replacement property (legal description, street address, or distinguishable name).
  • Identification Restrictions:
  1. Three-Property Rule: The Exchanger can identify up to three properties, regardless of their value.
  2. 200% Rule: The Exchanger can identify more than three properties as long as their aggregate fair market value does not exceed 200% of the fair market value of the relinquished properties.
  3. 95% Rule: The Exchanger can identify any number of properties, provided that at least 95% of their aggregate fair market value is actually received by the end of the exchange period.
  • Importance of a Contract: While the regulations require only written identification within 45 days, it is recommended to have a solid contract in place for the identified properties by the end of the 45-day period. Without a contract, the Exchanger may be unable to close on the identified properties.

The 180-Day Rule for Receipt of Replacement Property:

  • Completion Deadline: The Exchanger must receive the replacement property and complete the exchange no later than 180 days after the transfer of the relinquished property or by the due date of the Exchanger’s income tax return (including extensions) for the year in which the relinquished property was transferred.
  • Tax Return Due Date: If the Exchanger’s tax return is not extended, the 180-day period could be shortened to the return’s due date. Failure to extend the tax return could cause the 180-day period to end on the due date of the return.
  • Caution on Multiple Properties: If the Exchanger is selling two relinquished properties and buying one larger replacement property, the timing begins with the first relinquished property closing. The replacement property must be identified for both relinquished properties within 45 days, even if the second relinquished property is not sold.

By adhering to these strict deadlines and rules, Exchangers can ensure a successful delayed exchange and defer taxes on capital gains.

In a 1031 Exchange, “boot” refers to any non-like-kind property or money received by the taxpayer during the exchange. While the Internal Revenue Code doesn’t use the term “boot,” it is commonly used to describe the tax implications of the exchange. The goal is to defer taxes on the capital gains by exchanging like-kind properties, but if the taxpayer receives any “boot,” it can trigger taxable income.

What Constitutes Boot?

  1. Cash Boot: This is the net cash received from the exchange, which is the difference between the amount received from the sale of the relinquished property and the amount spent on the replacement property. Cash boot is typically incurred when the taxpayer is “trading down,” meaning the value of the replacement property is less than the relinquished property.

  2. Debt Reduction Boot: This occurs when the debt on the replacement property is less than the debt on the relinquished property. Similar to cash boot, debt reduction boot can result from “trading down” in the exchange.

  3. Sale Proceeds Used for Non-Qualified Expenses: If sale proceeds are used to pay non-transaction costs (e.g., service fees at closing), it is treated as if the taxpayer received cash from the exchange and used it to cover these costs.

  4. Excess Borrowing: Borrowing more money than necessary to purchase the replacement property may not result in tax-free money. If the funds from the loan exceed the amount needed for the replacement property, they will be returned to the Qualified Intermediary and used for other properties. Loan-related costs should be paid out of the taxpayer’s personal funds to avoid using exchange funds for non-qualified expenses.

  5. Non-Like-Kind Property: Receiving non-like-kind property, such as seller financing or a promissory note, in addition to the like-kind property (real estate), can also result in boot. For example, acquiring water rights or irrigation equipment with farm land might be considered non-like-kind by the IRS.

Boot Offset Rules:

  • Cash Boot Paid: The cash paid for the replacement property can offset the cash boot received from the relinquished property.
  • Debt Boot Paid: The debt assumed or paid for the replacement property offsets debt-reduction boot received from the relinquished property.
  • Cash Boot vs. Debt Boot: Cash boot received is taxable, but debt boot paid never offsets cash boot received. Cash boot paid can offset debt-reduction boot received.
  • Qualified Costs Paid: These costs, incurred during both the relinquished and replacement property closings, can offset net cash boot received.

Boot Tips:

  • Trade Across or Up: Always aim to trade equal or greater value. “Trading down” always results in boot, which could trigger taxes.
  • Bring Cash for Non-Qualified Expenses: Pay for items like loan fees or other charges that are not related to the exchange out of pocket, not with exchange funds.
  • Avoid Non-Like-Kind Property: Ensure that all property received in the exchange is like-kind (real estate for real estate).
  • Limit Financing: Do not over-finance the replacement property. Only finance enough to complete the purchase of the replacement property along with exchange funds.

In a 1031 Exchange, proper planning and execution are crucial to ensure tax deferral and compliance with the regulations. Here are some in-depth recommendations for successful exchanges:

Key DOs for 1031 Exchange Planning:

  1. Advance Planning:
    Speak with professionals like your accountant, attorney, broker, lender, and Qualified Intermediary (QI) well before initiating the exchange. Only a CPA or Tax Attorney familiar with your past tax returns and 1031 exchanges can provide the necessary advice to ensure compliance. This is critical because every taxpayer’s financial situation and prior tax records must be thoroughly considered for a successful exchange.

  2. Avoid Overfinancing:
    Overfinancing the replacement property can lead to tax issues. The IRS does not consider funds left over from excess financing as “loan funds.” These surplus funds are subject to tax consequences and could cause taxable income.

  3. Taxability of Credits on Closing Statements:
    If you receive any credit on the closing statement for your transaction, it is taxable. This credit reduces the exchange funds available to purchase your replacement property, which could limit the amount of like-kind property you can acquire.

  4. Adhere to Deadlines:
    Missed deadlines can disqualify your entire 1031 Exchange.

    • The 45-day identification period is a strict deadline to identify the replacement property.
    • The 180-day exchange period is the final deadline to acquire the replacement property. If you fail to meet either of these deadlines, your exchange will not qualify, and you will incur tax liability on the proceeds.
      A reputable QI will not backdate or accept late identifications.

  5. Rules for Full Tax Deferral:
    Ensure compliance with the following basic requirements for complete tax deferral:

    • Use all proceeds from the relinquished property to purchase the replacement property.
    • The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
    • Only like-kind property can be exchanged.

  6. Do Not Sell and Invest in Property You Already Own:
    You cannot sell and reinvest in property that you already own. For example, exchanging property in a way that involves reinvesting in your existing assets does not qualify for tax deferral under Section 1031. Only investments in properties that are truly like-kind to the relinquished property qualify.

  7. Sell Before You Purchase (Preferred):
    The most straightforward way to handle a 1031 Exchange is to sell the relinquished property before purchasing the replacement property. This ensures a clean and uncomplicated exchange. However, if you find the ideal replacement property before selling your relinquished property, you may need to consider a reverse exchange. Keep in mind that reverse exchanges are much more complex and costly.

    • The QI must take title to both properties in this scenario, adding more liability and administrative costs.
    • A reverse exchange also involves extra fees, including supplemental property taxes and state entity fees, making it a more expensive option than a standard exchange.

  8. Avoid Changing Title or Partnerships:
    During the exchange, do not dissolve partnerships or change the way the property is held in title. A change in the legal relationship with the property could jeopardize the 1031 Exchange and invalidate its tax benefits.

Key DON’Ts to Keep in Mind:

  1. Don’t Overfinance the Replacement Property:
    Overborrowing for the replacement property can lead to unwanted tax consequences. Borrowing more than what is necessary to close on the replacement property should be avoided, as it could lead to additional taxable income.

  2. Don’t Miss Important Deadlines:
    Missing the identification or exchange deadlines will disqualify the exchange. Always plan ahead and consult professionals to ensure all deadlines are met.

  3. Don’t Receive Non-Like-Kind Property:
    Receiving any non-like-kind property, such as personal property or a promissory note, will trigger taxable events and disqualify the exchange.

  4. Don’t Sell to Reinvest in Property You Already Own:
    Exchanging property with something you already own is not allowed. The exchange must involve truly like-kind properties to qualify for tax deferral.

  5. Don’t Dissolve Partnerships or Change Title Ownership:
    Any change in the ownership structure or legal relationship with the property could invalidate the exchange and create tax liabilities.

By following these strategies and avoiding common pitfalls, you can ensure a successful 1031 Exchange with full tax deferral.

The role of a Qualified Intermediary (QI) is critical to completing a successful 1031 Exchange. The QI is the central entity that facilitates the exchange process, ensuring compliance with IRS regulations and enabling tax deferral for the taxpayer. Here’s an overview of the role and responsibilities of the QI, as well as important details regarding their involvement in the exchange:

Role and Importance of the Qualified Intermediary

The Qualified Intermediary (QI) is integral to the delayed exchange process, as they hold the proceeds from the sale of the relinquished property and use those funds to purchase the replacement property on behalf of the taxpayer. Without a QI, the taxpayer would have constructive receipt of the funds, disqualifying the exchange for tax deferral.

  • Safe Harbor: To qualify for the QI “safe harbor,” there must be a written agreement between the taxpayer and the QI. This agreement restricts the taxpayer’s ability to receive, pledge, borrow, or access the exchange funds during the exchange period.
  • The QI is not an agent of the taxpayer in a traditional sense (under state law), but for the purposes of the exchange, the intermediary acts as the taxpayer’s agent in the context of the exchange transactions.

Key Responsibilities of the Qualified Intermediary

  1. Coordinate the Exchange:
    The QI collaborates with the taxpayer’s advisors (attorneys, accountants, brokers) to structure a compliant and successful exchange.

  2. Prepare Documentation:
    The QI ensures that all required documents for both the relinquished property and replacement property are prepared accurately.

  3. Escrow Services:
    The QI furnishes escrow instructions and documentation to facilitate the proper transfer of the properties.

  4. Hold and Protect Funds:
    The QI holds the exchange funds in an insured bank account until the exchange is completed, ensuring the taxpayer does not have access to the funds, which is necessary for tax deferral.

  5. Transfer of Property:
    Upon successful identification and acquisition of the replacement property, the QI will provide the necessary documents to transfer the replacement property to the taxpayer and ensure the disbursement of exchange proceeds into escrow.

  6. Document Identification of Replacement Properties:
    The QI receives and holds the taxpayer’s document identifying the potential replacement properties (within the 45-day identification period).

  7. Provide Accounting:
    The QI offers a full accounting of the exchange funds, which is crucial for the taxpayer’s records and tax reporting.

  8. Tax Reporting:
    The QI submits a 1099 form to both the taxpayer and the IRS for any taxable growth proceeds, ensuring the taxpayer complies with IRS requirements.

Disqualifications and Requirements for QIs

  • The QI cannot be a disqualified person, which includes accountants, attorneys, and real estate agents who have worked with the taxpayer within the prior two years. These parties are prohibited from acting as a QI due to potential conflicts of interest.
  • There are no licensing requirements for Qualified Intermediaries, but they must meet the necessary qualifications under the Internal Revenue Code to act in this capacity.

Additional Considerations

  • The QI does not provide legal or tax advice; instead, their role is to manage the mechanics of the exchange process.
  • The QI helps to avoid constructive receipt of exchange proceeds, which could trigger taxable events. The intermediary ensures the funds are used solely for the purchase of like-kind replacement property.

In summary, a Qualified Intermediary plays a pivotal role in ensuring that a 1031 Exchange is structured correctly and complies with all IRS rules. They help taxpayers avoid taxable events by acting as the custodian of exchange funds, preparing documentation, coordinating the exchange process, and ensuring timely reporting and compliance.

If the value of the property decreases, you can still complete a 1031 Exchange to defer part of your transaction, but you will owe taxes on any “boot” you receive once the exchange is finalized. The cost of the replacement property may be lowered by the expenses associated with broker commissions, escrow, and title fees for all transactions involved in the exchange.

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The following are examples of properties that qualify for a 1031 Exchange:

  • Bare land …………… Farmer’s land
  • Commercial rental ………… Residential rental
  • Industrial property ………… Doctor’s office
  • 30-year leasehold interest ………… Percentage interest in investment property
  • Cement truck ………… Cement truck

To qualify for §1031 treatment, the Exchanger must hold the relinquished property for investment or productive use in their trade or business. The key factor is the Exchanger’s intent in holding the property, rather than the type of property itself. Properties held for personal use will not qualify for §1031 treatment. For instance, second homes won’t qualify unless the owner changes how the property is used. A taxpayer could convert a second home to a qualifying exchange property by renting it out and treating it as a legitimate Tenant-in-Common (TIC) investment. It’s important to consult with a tax advisor when the intent behind holding property changes.

Property held “primarily for sale” is also ineligible for §1031 treatment. This includes most properties held by developers, builders, or individuals engaged in rehabilitation, as these are typically held for sale. When sold, these properties are subject to ordinary income tax, not capital gains tax.

Partnership interests, notes secured by real property, contract vendor interests, and foreign property (as per the Revenue Reconciliation Act of 1989) are not eligible for §1031 treatment.

A crucial factor in partnerships involving 1031 exchanges is determining whether the entire partnership intends to engage in the exchange, or if some partners wish to defer capital gains taxes under IRC §1031. If the partnership meets the necessary criteria for exchange transactions—meaning both the relinquished and replacement properties are held for investment or income purposes—then the entire partnership can proceed with a valid tax-deferred exchange.

A common question is whether one or more partners can exit the partnership and exchange their interest for a like-kind replacement property. Since a partnership interest is personal property, one possible solution is to liquidate the partnership under IRC §708, allowing each partner to hold their respective interest as tenants-in-common with the other former partners.

If the partnership is liquidated, the next issue is whether the relinquished property was held for productive use in a trade or business or for investment purposes. Both the IRS and the Tax Court tend to apply the substance-over-form doctrine in these cases. In Bolker v. Commissioner (1983) and Magneson v. Commissioner (1985), the taxpayers’ transactions qualified under IRC §1031.

Such transactions can be complex and should be thoroughly reviewed by qualified tax and legal professionals to ensure the facts and circumstances are sufficient to support a tax-deferred exchange. For instance, in Chase v. Commissioner (1989), the taxpayer was denied non-recognition treatment for failing to properly liquidate a partnership interest before the exchange.

TAX REFORM ACT OF 1984: This Act addressed the IRS’s issues with the Starker decision, allowing Delayed Exchanges, but only if both the relinquished and replacement properties are identified and acquired within strict deadlines. It emphasized that a simple “sale” followed by reinvestment doesn’t qualify for tax deferral under Section 1031. To qualify, the exchange must be carefully structured to avoid triggering a taxable sale.

1991 REVISIONS: The IRS revised the Tax Reform Act of 1984 to provide clearer terminology and officially accepted Delayed Exchanges instead of opposing them.

Relinquished Property: Also called “Downleg” or “Sale Property,” this is the property you currently own and plan to sell or exchange.

Replacement Property: Also called “Upleg” or “Purchase Property,” this is the property intended to be bought with proceeds from the sale of the relinquished property. There are limits on how many replacement properties can be identified in a deferred exchange, and exceeding this limit can cause the entire exchange to fail.

Like-Kind Property: Refers to the intended use of the property rather than its quality or grade. For example, you can exchange a condo for a duplex, or a commercial building for vacant land. For personal property, the definition of “like-kind” is stricter. Also, properties outside the U.S. cannot be exchanged with properties within the U.S.

Boot: Non-like-kind property received in an exchange, such as cash, notes, or furniture.

Constructive Receipt: When a taxpayer controls the proceeds, even if they don’t physically possess the funds.

Exchanger: The property owner(s) looking to defer taxes through a Section 1031 exchange.

Qualified Intermediary: An entity that facilitates the exchange for the Exchanger. They are not related to the Exchanger and are responsible for receiving and transferring the relinquished and replacement properties. They are also called “facilitators” or “accommodators.”

IDENTIFICATION PERIOD: The replacement property must be identified within 45 days after the sale of the relinquished property. This deadline is strict, even if it falls on a weekend or holiday.

EXCHANGE PERIOD: The replacement property must be received within 180 days from the transfer of the relinquished property, or by the tax return due date for that year, whichever comes first.

DEFERRED EXCHANGE: A type of exchange where the Exchanger uses the exchange period to complete the exchange, replacing the old term “Non-Simultaneous Exchange.”

STARKER: A case name that authorized Delayed Exchanges; the term “Starker Exchange” is no longer used.

SEQUENTIAL DEEDING: The property is deeded to the intermediary, who then deeds it to the final owner.

DIRECT DEEDING: The owner deeds directly to the new owner, but the Qualified Intermediary still facilitates the exchange by acquiring and transferring both the relinquished and replacement properties.

EXCHANGE AGREEMENT: A formal agreement that outlines the exchange process, where the Exchanger transfers the relinquished property and receives the replacement property. This agreement is crucial for a deferred exchange.

One of the main benefits of §1031 exchanges when dealing with real property is the “like-kind” provision. All real estate qualifies as like-kind with other real estate, meaning the type or character of the property doesn’t matter, but rather how the property is held by the investor. The Exchanger must have held the relinquished property for investment or productive use in their trade or business and plan to do the same with the replacement property. Examples of like-kind property exchanges include:

  • Residential for commercial
  • Bank building for swamp land
  • Bare land for residential rental
  • Fee simple interest for 30-year leasehold
  • Single-family rental for multi-family rental
  • Non-income-producing property for income-producing property
  • Rental mountain cabin for a dental office where the Exchanger intends to practice

For personal property exchanges, the rules are much stricter. Definitions of real versus personal property can vary by state, so it’s crucial to consult a tax advisor when structuring personal property exchanges. A single transaction may involve both real and personal property exchanges for tax deferral. Personal property is considered like-kind only if it falls under the same General Asset Class or Product Class. Some examples of exchanges involving personal property include:

  • Dump truck for a dump truck
  • Garbage routes for garbage routes
  • Tofu equipment for tofu equipment

The IRS clarified in PLR 20040002 that a taxpayer can acquire replacement property from a related party if the related party is also engaging in an exchange. This interpretation was reaffirmed in PLR 200616005, where the IRS ruled that a taxpayer could sell relinquished property A to an unrelated buyer through a qualified intermediary (QI) and acquire replacement property B from a related S corporation, as long as the related party was also conducting an exchange. The related party, in this case, was not “cashing out” of the property. Both the taxpayer and the related party confirmed their intention to hold their respective replacement properties for at least two years. This ruling is similar to the earlier PLR 20040002. However, in this case, the taxpayer also intended to acquire additional replacement property from an unrelated seller and acknowledged that if unable to do so, they would pay tax on any cash received. The IRS ruled that this taxable boot would not invalidate the entire related-party exchange.

The Private Letter Ruling (PLR 200616005) provides further details on the exchange involving related parties under IRC Section 1031, including specific facts, tax law, and the IRS’s final decision on how the exchanges and potential taxable boot should be handled.

To determine your capital gain, begin with the original purchase price of your property, then add any capital improvements and subtract depreciation. This will give you your adjusted basis. Subtract the adjusted basis and the sale-related costs from the sale price, and the remaining amount is your gain.

It’s important to distinguish between capital gain and equity, as they are not interchangeable. Equity is the amount of money left after selling the property and paying off any related debts or mortgages.

For example, if you bought a property for $200,000 five years ago, with a mortgage of $130,000 and an adjusted basis of $166,667, and you sell it today for $400,000, paying $30,000 in closing costs and commissions, your equity would be $240,000 (the amount you receive after the sale). However, your capital gain would be the difference between your basis ($166,667) and the adjusted sales price ($370,000, after subtracting costs from the sale price), which equals $203,333. If you don’t use a 1031 Exchange, you’ll owe taxes on the entire gain, which would amount to $30,499.95 in federal taxes, assuming a 15% federal tax rate. Be careful if you’ve refinanced your property since the original purchase, as this could complicate matters. In such cases, it might be better to consider an exchange unless you have the funds to cover the taxes. For instance, if a taxpayer bought property for $100,000 with a $70,000 mortgage, and the value rises to $210,000, with a new mortgage of $140,000, selling the property for $210,000 without a 1031 Exchange would result in a $110,000 gain, triggering $16,500 in federal taxes. Larger transactions, involving more money and leverage, will result in higher taxes when cashing out. Consulting with a tax advisor is essential in such situations.

A build-to-suit exchange, also known as a construction or improvement exchange, is a tax-deferred exchange where the Qualified Intermediary acquires fee ownership of the replacement property and makes improvements to it [Treas. Reg. §1.1031(k)-1(e)]. After completing the necessary improvements within the exchange period (180 days), ownership is transferred to the Exchanger, finalizing the exchange. This type of exchange offers greater flexibility for investors, allowing them to either improve an existing property or build a new one.

Exchangers should consider a build-to-suit exchange when the value, debt, or equity of the replacement property is insufficient to fully defer capital gain taxes. This happens when purchasing replacement properties results in reduced debt or equity. Exchange proceeds or additional debt can be used to fund improvements on the replacement property. If additional debt is used, the Qualified Intermediary should execute the necessary loan documents.

Regulations require that the identification of the replacement property be made no later than the 45th day of the exchange period, and it must include as much detail as possible about the planned improvements [Treas. Reg. §1.1031(k)-1(e)(2)(I)]. Typically, the Qualified Intermediary will request a legal description of the property, along with floor plans, specifications for new construction, or a full description of renovations.

Advance planning is crucial due to factors such as weather, local permits and approvals, construction delays, and labor shortages, which may limit the scope of improvements that can be completed within the exchange period. The tax code allows only 180 days from the closing of the relinquished property to acquire the replacement property, and this deadline applies to build-to-suit exchanges as well. However, not all improvements need to be completed within the 180-day period. To achieve full deferral of capital gains taxes, the Exchanger must receive title to the replacement property, which must be fully funded by the exchange proceeds and have a fair market value equal to or greater than the relinquished property.

With the introduction of Revenue Procedure 2000-37 (the “Rev. Proc.”), it is now possible for a taxpayer to acquire and use replacement property before selling the relinquished property. The Rev. Proc. provides a “safe harbor” presumption that the exchange qualifies under §1031, provided certain conditions are met.

In a Reverse Exchange, the same rules apply as in a regular 1031 Exchange. The proceeds from the sale of the relinquished property must be used to purchase the replacement property. However, since the replacement property is acquired before the relinquished property is sold, the Exchanger must secure the necessary funds from another source to purchase the replacement property.

This means the Exchanger must loan the LLC formed by the Qualified Intermediary for the Reverse Exchange the expected proceeds from the sale of the relinquished property. The Exchanger will be repaid once the relinquished property is sold. If the proceeds from the sale exceed the loan amount, the difference may be taxable unless a delayed exchange is performed to handle the balance, which would involve identifying and purchasing another replacement property. It’s advisable to clearly outline such details in the Exchange Agreement from the start.

Exchange First

The type of Reverse Exchange used depends on whether the Exchanger will finance the purchase of the replacement property. In a Reverse 1031 Exchange that requires financing, the “Exchange First” method is used.

Here’s a simplified Reverse Exchange scenario where the purchase and sale price for both the replacement and relinquished properties are $2 million:

  1. The Exchanger contracts to purchase the replacement property and includes an Exchange Clause in the contract.
  2. The Exchanger calculates the expected proceeds from the relinquished property sale and secures those funds as a loan to bring to closing. In this example, the proceeds are estimated at $1.1 million.
  3. The Exchanger arranges financing, using the $1.1 million as the down payment for the replacement property.
  4. Due diligence on the replacement property is completed.
  5. The Exchanger works with Haven Exchange to arrange the Reverse Exchange.
  6. Haven Exchange creates an LLC in the same state as the replacement property.
  7. At closing, the LLC acquires the replacement property through a double escrow. The LLC borrows the $1.1 million from the Exchanger to acquire the property and simultaneously transfers the replacement property to the Exchanger in exchange for the relinquished property. The Exchanger’s new lender funds this escrow.
  8. The relinquished property is sold within 180 days, and the proceeds are used to repay the loan from the Exchanger to the LLC, completing the Reverse Exchange.

Exchange Last

In a “safe harbor” Reverse Exchange, the taxpayer locates the replacement property first. The taxpayer then enters into a purchase contract and an Exchange Agreement with the Qualified Intermediary (QI), which forms an Exchange Accommodation Titleholder (EAT) to hold title to the property.

The EAT becomes the purchaser and, if the taxpayer (or a third-party lender) loans the expected proceeds from the relinquished property sale to the EAT, the EAT uses those funds to buy the new property. The EAT then leases the property back to the taxpayer. After the relinquished property is sold, the EAT transfers the new property to the taxpayer in exchange for the old property. The proceeds from the relinquished property are used to repay the loan, and this is not taxable.

To qualify under the “safe harbor” presumption, the taxpayer must identify the relinquished property within 45 days of the EAT purchasing the new property and complete the exchange within 180 days. If these deadlines are not met, the “safe harbor” presumption is lost, but tax deferral may still be achieved through a Reverse Exchange structure.

In situations where the “safe harbor” presumption is not available, the relationship between the EAT and the taxpayer must be structured as an “arms-length” arrangement, with the EAT having sufficient risk in the transaction. In these cases, the EAT may invest a small percentage of its own funds in the property, and the taxpayer may have a short window to purchase the property.

Non-safe harbor Reverse Exchanges are often used in cases where modifications are required to the property before it can be used (e.g., specialized aircraft or equipment). The EAT in these situations might need to be involved in the construction process.

For all Reverse Exchanges, the EAT must be treated as the taxpayer for tax purposes, including filing returns for the property it holds. It’s advisable to structure each Reverse Exchange with a separate single-purpose entity (SPE) to protect the parties involved. The transaction must be carefully structured at both the organizational and relational levels to ensure compliance with IRS requirements or to ensure the EAT is sufficiently at risk in the transaction.

Last spring, Chris Hiza from Milford, Conn., wanted to exchange two rental properties for others that he believed would increase in value over time. Rather than selling his two three-family rentals, paying taxes on the gains, and using the remaining funds to purchase new ones, he opted for a 1031 exchange. This allowed him to reinvest all the proceeds from selling his properties into new ones, without incurring taxes on the profits.

A “1031 exchange” is a section of the IRS code that permits real estate investors to defer taxes on the gains from selling investment properties, as long as they invest the proceeds into other properties of equal or greater value. The seller must identify the property they wish to purchase within 45 days of selling their existing property and finalize the purchase within 180 days. Typically, a third-party intermediary manages the transaction.

In Hiza’s case, he was able to sell his two rental properties in West Haven, Conn., without paying federal and state taxes, which allowed him to purchase four three-family rental homes in a desirable New Haven area.

“The 1031 exchange was a strategy to upgrade for the long term and shelter the gains,” says Hiza, 43. “Since we would have had a 24% combined tax rate, this boosted our purchase by 24% per property. That’s significant.”

More real estate investors are taking advantage of the 1031 exchange to buy and sell properties, with most transactions involving one- to four-family rental homes worth around $500,000 to $700,000, according to tax and real estate experts. However, many investors make mistakes that result in the IRS disqualifying their exchange due to a lack of understanding of the rules. Hiza’s successful 1031 exchange was the result of careful planning and researching properties before selling his old ones, enabling him to complete the transaction within the required timeframe.

“Don’t wait until the last minute,” he advises. “Start looking for replacement properties early, get prequalified for financing, and work with Realtors, attorneys, and intermediaries.”

Common mistakes real estate investors make with 1031 exchanges include:

  • Assuming a personal residence qualifies: Only investment properties like rentals, business properties, or land held for investment purposes are eligible for a 1031 exchange. Properties bought for quick resale or construction do not qualify.

  • Attempting an exchange after selling: Investors must establish an exchange agreement with a qualified intermediary before selling their property.

  • Choosing an unreliable intermediary: It’s important to select an experienced and trustworthy intermediary, as they manage the sale proceeds. Some intermediaries may not be federally insured, so it’s essential to work with reputable firms.

  • Selling too soon: The IRS doesn’t specify how long an investment property must be held before selling, but selling it quickly suggests it was never intended for long-term investment. A general guideline is holding the property for at least two tax years.

  • Ignoring the 45-day and 180-day deadlines: The seller has 45 days to identify replacement properties and 180 days to purchase them. Missing these deadlines or being vague about the properties being considered can disqualify the exchange.

  • Rushing the research process: Many investors don’t thoroughly research their options, which can lead to bad investments. It’s important to plan ahead, assess the market, and ensure that the property you’re purchasing aligns with your investment strategy.

Hiza emphasizes the importance of planning ahead and being clear about what you want to buy before selling. He was determined not to settle for a property just to meet the exchange deadline.

— Ms. Capell is a senior correspondent for CareerJournal.com.

The Buyer acknowledges that the Seller intends to execute an IRC § 1031 tax-deferred exchange, and that this will not delay the closing or incur additional costs for the Buyer. The Seller may assign their rights and responsibilities under this agreement to Haven Exchange, Inc., a Qualified Intermediary, to facilitate the exchange. The Buyer agrees to cooperate with the Seller and Haven Exchange, Inc. as necessary to complete the exchange.

Similarly, the Seller acknowledges that the Buyer intends to execute an IRC § 1031 tax-deferred exchange, and that this will not delay the closing or incur additional costs for the Seller. The Buyer may assign their rights and responsibilities under this agreement to Haven Exchange, Inc., a Qualified Intermediary, to facilitate the exchange. The Seller agrees to cooperate with the Buyer and Haven Exchange, Inc. as necessary to complete the exchange.

Yes, a qualified intermediary is needed if more than two properties are involved. If two Exchangers wish to swap properties directly, a qualified intermediary is not necessary. However, if three or more properties are part of the exchange, either someone must manage the chain of title to facilitate the exchange, or a qualified intermediary is required to prepare the necessary documents for the IRS to validate the transaction.

Real property cannot be exchanged for improvements, as they are not considered like-kind. Additionally, you cannot complete a trade if you own both properties simultaneously. Although recent court rulings have been favorable, it’s best to avoid acquiring the replacement property until the improvements are completed. There are methods to make the improvements tax-deductible—contact us for more information.

The same entity that disposes of the property must also acquire property to qualify for an exchange. If some partners prefer cash and do not wish to exchange, they can be cashed out when the sale closes, allowing the partnership to remain intact and acquire property. However, if partners wish to separate but still complete an exchange, the partnership must deed the appropriate ownership percentages to each partner before the sale closes. There is a risk involved, as §1031 requires property to be held for productive use in business, trade, or investment. If the property is deeded to individual partners, the question arises whether it has been “held” by the individuals. It is important to consult with your CPA or tax advisor for guidance.

Borrowing or using the funds as collateral would indicate the Exchanger’s control over the money, which would make it taxable and invalidate the exchange.

Yes, but any interest accrued by the Exchanger can only be released once the exchange is completed. If the Exchanger receives the interest before then, it would be considered “constructive receipt” of the funds, causing the exchange to be invalid. The Qualified Intermediary will provide a 1099 statement for the tax year in which the interest is actually paid to the Exchanger.

Purchase as many properties as you can afford and are able to close within the designated time frame. Sell as many properties as possible, as long as they can all close within the time limits established by the first sale’s closing.

If you sell a property solely owned by you, and your spouse has no interest in the old property but joins you in acquiring a new property, the IRS may only credit you for half of the purchase. Depending on the property values and whether you live in a community property state, this could lead to a substantial tax liability. It might be wise to add your spouse to the title of the relinquished property before starting escrow.

To comply with tax-deferred exchange regulations, the Exchanger’s access to the funds must be restricted. The exchange agreement must ensure that the Exchanger does not receive any proceeds before the 46th day. If the Exchanger fails to identify replacement property within 45 days, they may receive the funds on the 46th day. If the Exchanger identifies a property but fails to acquire it (unless the property is destroyed), they may receive the funds on the 181st day.

The Exchanger cannot receive any funds held by the Qualified Intermediary until the 46th day, if no replacement property has been identified, or if all identified properties have been acquired by the Exchanger. If a property was identified but not acquired (unless it has been destroyed), the funds cannot be disbursed to the Exchanger until the 181st day.

Vacation homes are subject to strict criteria to determine whether they qualify as investment property. If the property was rented out while you owned it, it may be eligible for tax deferral. Additionally, if you haven’t personally used the property, you may be able to persuade the IRS that it was solely held for investment purposes. It’s best to consult with your CPA for guidance.

A vacation or second home that isn’t rented out is considered personal property and doesn’t qualify for §1031 treatment. However, according to §280 rules, a property used for both personal and rental purposes must undergo an annual use test to determine its tax classification:

  1. The property is classified as primarily for personal use and not held for profit if the owner uses it for more than 14 days or 10% of the total rental days, and the property is rented for at least one day during the year. This property does not qualify for §1031 treatment.

  2. The property may qualify for §1031 treatment if the owner’s personal use is limited to 14 days or 10% of the rental days, and the property is rented for more than 14 days during the year. In this case, it is treated as a TIC investment.

The IRS disqualifies any agent of the Exchanger, as well as any related party, from acting as a qualified intermediary. If you’re uncertain whether someone qualifies as an agent or related party, they likely do. A relationship through contract or blood could disqualify the exchange. For clarity, refer to the “Related Party” section. Given that intermediary fees are affordable, it’s not worth risking potential tax consequences.

The 45-Day Rule for Identification:

The first timing requirement for a delayed Section 1031 exchange is that the taxpayer must either close on the replacement property or identify it within 45 days from the transfer date of the relinquished property. The 45-Day Rule is met if the replacement property is acquired within 45 days. If not, the taxpayer must provide a written identification notice, signed by them, and sent to the intermediary via hand delivery, mail, or fax. This notice must clearly describe the replacement property, including the legal description, street address, or a distinguishable name for real property.

There are limits on the number of replacement properties that can be identified. More than one property can be listed if one of these rules is followed:

  • The Three-Property Rule: You can identify up to three properties regardless of their market value.
  • The 200% Rule: Any number of properties can be identified as long as the total fair market value of the identified properties does not exceed 200% of the total market value of the relinquished properties on the date of transfer.
  • The 95% Rule: You can identify any number of replacement properties if the actual value of the properties received at the end of the exchange period is at least 95% of the total fair market value of all identified replacement properties.

Although the regulations only require written identification within 45 days, it’s best practice to have a solid contract in place by the end of the period. Without it, the taxpayer may be unable to complete the exchange on any identified properties. After 45 days, no new properties can be identified, and failure to submit the identification notice will result in the termination of the exchange agreement, with unused funds being returned to the taxpayer by the intermediary.

Caution: If the exchanger is selling two properties and purchasing one larger replacement property, the 45-day period starts when the first relinquished property is sold. The replacement property must be identified for both relinquished properties within 45 days of the first sale, regardless of whether the second property has been sold.

A seller carry-back can be classified as an installment sale or, under certain conditions, may be eligible for deferral (contact us for a detailed review). The key point is that the way a carry-back is handled can have significant tax implications for the Exchanger, so it’s crucial to discuss and decide on the approach before the sale closes.

The cooperation clause is meant to explicitly demonstrate the Exchanger’s intention to complete an exchange. This can be achieved by including the statement after the initial offer acceptance but before the sale closes.

Alternatively, the buyer can sign the Assignment of the Purchase Contract, prepared by the Qualified Intermediary, which is the extent of cooperation needed. For negotiation purposes, it’s ideal to secure an agreement to cooperate early in the process.

Funds can be allocated to escrow for earnest money and common expenses, such as preliminary title reports, appraisals, and credit reports, once the Qualified Intermediary is assigned to the transaction in place of the Exchanger.

Escrow must request the funds, not the Exchanger, to prevent issues with the Exchanger having control over the funds. If the Exchanger advances any of these funds through escrow, they can be reimbursed at the close of escrow without triggering taxes. However, it’s important to note that loan fees are considered “boot,” and if exchange funds are used to cover them, it will result in a taxable event.

A Delayed Exchange, which is the most commonly used type of 1031 exchange and the focus of this guide, occurs when the replacement property is acquired after the sale of the exchange property. The exchange does not need to happen on the same day. This type of exchange is sometimes called a “Starker Exchange,” named after a Supreme Court case where the court ruled in favor of the taxpayer for a delayed exchange before the IRS allowed for such exchanges under the Internal Revenue Code. Strict timeframes, such as the 45-Day Clock and the 180-Day Clock, are established for completing a delayed exchange.

A Reverse Exchange (also known as a Title-Holding Exchange) happens when the replacement property is purchased before the exchange property is sold. The Qualified Intermediary typically creates a single-purpose LLC, which holds the title to the replacement property until the taxpayer sells their exchange property. The replacement property can be used by the taxpayer during the exchange, and once the exchange property is sold, the title to the replacement property is transferred to the taxpayer.

An Improvement Exchange (or Build to Suit Exchange) involves acquiring a property and making improvements before it is considered as replacement property. These improvements may include building a structure on an unimproved lot or enhancing an existing property to increase its value. The IRS requires a Qualified Intermediary to set up a single-purpose LLC to acquire and hold title to the property until improvements are completed. The LLC then transfers the improved property to the taxpayer as the replacement property. After the exchange is finished, the LLC is dissolved, and its tax return is filed by the Qualified Intermediary.

A Simultaneous Exchange is an exchange where the closings of both the relinquished property and replacement property happen on the same day. This is the only type of exchange covered by the “safe harbor” regulations and does not require a Qualified Intermediary to facilitate the exchange. However, the closings must occur without delay, as even a short delay could result in the exchange failing, potentially triggering full tax liability. Many people opt for a delayed exchange, as it allows for more time between closings, reducing the risk of a failed simultaneous exchange.

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