What is the 1031 Exchange?

Key Takeaways

• Under the IRS, the 1031 exchange essentially permits someone who owns investment property to sell it and purchase other property while deferring capital gains taxes.

• A qualified intermediary is an individual or entity that agrees to assist in the 1031 exchange by holding transaction funds until they can be shifted to the seller of the replacement real estate.

• To receive an exchange’s full benefit, the investor’s replacement property must be of the same or greater value as the property sold.

It is important for real estate investors, and those considering such investments, to know about the 1031 exchange — which derives its name from Section 1031 of the IRS code — as it permits avoidance of capital gains taxes. This frees more capital for investment in replacement real estate. But what is the 1031 exchange? Here is that and more.

Define 1031 Exchange?

Under the IRS, this procedure essentially permits someone who owns investment property to sell it and purchase other property while deferring capital gains taxes.

Specifically, the 1031 exchange allows investors to put off such taxes when they sell an investment property and use the proceeds, within certain time limits, to buy “like kind” real estate.

Note that if an investor’s heirs inherit property gained through such an exchange, all deferment taxes are erased.

When Can I Use a 1031 Exchange?

While the chief exchange benefit is tax deferral, other reasons investors may wish to use a 1031 exchange include:

• When they are seeking a property that potentially has better returns.
• When they are seeking a managed property, rather than have to manage one themselves.
• When they wish to consolidate multiple properties for real estate planning, for instance, or when they want to divide a property into multiple assets.

Investors may also be motivated to seek an exchange by property depreciation – the percentage of the cost of real estate that is written off annually due to normal wear and tear. If a property’s sale price exceeds its depreciated value, the investor may want to “recapture” the depreciation. They can do that by adding the depreciation amount to the taxable income from the property sale. Because the recaptured amount increases over time, the investor may wish to escape the substantial future taxable income hike by using a 1031 exchange.

What are the Rules and Requirements?

When it comes to selecting a replacement property, rules and timing must be considered. One important rule has to do with like-kind property.

Instead of grade or quality, a like-kind property is defined based on its characteristics, function, or nature. Therefore, there is wide range of real properties that are exchangeable. For instance, a commercial building can be exchanged for empty land, and a residential property can be swapped for commercial. However, artwork would not be exchangeable, for example, because it does not meet the definition of like-kind in the eyes of the IRS.

Time-wise, receiving an exchange’s full benefit requires the investor’s replacement property to be of the same or greater value. Within 45 days of the sale, the investor must “identify” replacement real estate and finish the exchange within 180 days. There are two rules regarding identification requirements; the investor must meet just one.

• With the 200% rule, the investor can identify an unlimited number of replacement properties, with a proviso: the properties’ cumulative value is not more than 200 percent of the value of the sold property.
• Under the three-property rule, investors can identify three properties as prospective purchases, their market values notwithstanding.

Moreover, the vast numbers of potential exchanges vary in their timing and other minutia, and thus have their own procedures and requirements. Here are the different types of like-kind exchanges:

• Delayed exchanges are 1031 exchanges that occur within 180 days. They are called that because, in the past, exchanges were required to take place at the same time.
• Build-to-suit exchanges permit a replacement property to be newly constructed or renovated. These kind of exchanges, though, must still comply with the 180-day rule. This means that all work must be completed by the time the transaction is complete.
• A reverse exchange is when a replacement property is acquired before the property to be exchanged is sold. In such an occurrence, the property must be shifted to an exchange accommodation titleholder (or qualified intermediary) and an agreement must be signed. A property for exchange must be identified within 45 days of property transfer, and the transaction must take place within 180 days.

Another rule is that like-kind properties must also be of similar value. A “boot” is the difference in value between a property and the real estate being exchanged. If a replacement property is valued less than the property sold, the difference is taxable.

Note that a mortgage is allowed on either side of the 1031 exchange. If the mortgage on the property being sold is more than the one on the replacement, the difference is viewed like a cash boot.

There are expenses and fees that can be paid with exchange funds since they affect the traction’s value and thus the prospective boot. They include applicable escrow, finder, tax adviser, attorney, filing, and qualified intermediary fees, in addition to the broker’s commission and title insurance premiums.

How Does the 1031 Exchange Rule Work?

After identifying the property the investor wishes to sell, and the one they want to buy, the investor must choose a qualified intermediary, as discussed below. They must also apprise the IRS of the exchange via Form 8824, which must be filed with one’s tax return in the year the exchange took place.

The form requires a description of the exchanged properties, identification and transfer dates, characterization of any relationship with the party with whom the real estate was exchanged, and the like-kind property’s value. Also required is disclosure of the property’s adjusted basis as well as any liabilities assumed or relinquished.

There is no limit on how frequently one can do a 1031 exchange for like-kind properties. An investor can continue to roll over property gains and avoid paying taxes until at some point in the future when the property is sold for cash.

Not that when an investor sells a property, proceeds remain taxable. Therefore, under IRS Section 1031, sale proceeds must be shifted from the property seller to what is called a qualified intermediary. The intermediary must hold the proceeds in escrow, then subsequently transfer proceeds to the seller of the replacement real estate.

A qualified intermediary is an individual or entity that agrees to assist in the 1031 exchange by holding transaction funds until they can be shifted to the seller of the replacement real estate. The buyer may not, at any time, hold the proceeds from the sale during an exchange.

No other formal relationship is permitted among the qualified intermediary and the parties that are exchanging property. Such transactions, by the way, should be handled by professionals.

1031 Exchange vs. Traditional Sale

The chief difference between the two is that in a traditional real estate sale, the owner must pay any gains realized on the property sold.

Another advantage of exchanges is potential portfolio expansion since investors can continually put capital in new investments and can even trade up and enter new real estate markets. There are risks, though, including potentially higher future taxes and deferred losses, which cannot be claimed in market downturn years.

Overall, more so than with traditional property sales, the rules regarding exchanges can be relatively complex.

What is an Example of a 1031 Exchange?

A woman named Nancy owned an apartment building that is valued at $2 million — twice what she bought it for seven years ago. At length, her broker informed her of a bigger condo on the market for $2.5 million in an area that is charging higher rents.

Through an exchange, Nancy sold her building and used the proceeds toward the larger replacement property, sans any concerns about a looming capital gains and depreciation recapture liabilities.

What are Some Other Ways to Be Profitable in the Real Estate Industry?

Real estate continues to be a popular investment. Not only can it provide a natural hedge against inflation, but it has a low correlation to volatile public markets and is generally tax efficient. In nearly the last 25 years, on an absolute and risk-adjusted basis, private real estate alone has outperformed U.S. equities.

And the market is no longer reserved for institutional investors, thanks to alternative investment platforms such as Yieldstreet – which offers more asset classes than any other platform. Yieldstreet’s multi-step asset vetting process, which helps mitigate risk, also sets it apart.

In particular, Yieldstreet has made private and commercial real estate investing accessible and easy, with net annualized returns of 9 percent and income and growth opportunities . While the platform’s active-investment portfolio is diversified across asset classes, real estate has the largest concentration.

What’s mor, compared with the fourth quarter of last year, the total amount invested on the Yieldstreet platform increased 7 percent in the first quarter of this year, with a continued focus on commercial real estate offerings.

Another reason real estate is so popular is that as an alternative investment – essentially any asset other than stocks and bonds – it helps to diversify one’s investment portfolio. Diversification, which is key to successful investing, is a tool that lets investors minimize losses while benefiting from prospective gains.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

It is important for those who are mulling selling their investment property and buying another property to be aware of the 1031 exchange, so that they can take advantage of deferred capital gains taxes and other benefits.

It is also important for investors to understand other ways to generate profit in real estate that once were only accessible to institutional investors.