What is a 1031 exchange?

A 1031 exchange is a tool used by real estate investors to defer gains on qualifying real property by investing the gains into another like-kind property. It is important to remember that the taxable gains are deferred and not eliminated. This is done by reducing the cost basis of the replacement property by the deferred gain. When the replacement property is eventually sold, the deferred gain on the original property and any gain on the replacement property will become taxable.

Recent Changes to Like-Kind Exchanges

Prior to 2018, like-kind exchanges could be completed with any asset used in a trade or business or held for investment if it was exchanged for like property. The Tax Cuts and Jobs Act of 2017 (TCJA) modified the exchange provisions of IRC Section 1031. For exchanges after 2017, the like-kind exchange rules apply only to exchanges of real property held for productive use in a trade or business or for investment. To qualify as a like-kind exchange both the relinquished and replacement property must be held for productive use in a trade or business or for investment.

Requirements and Considerations for Real Estate Investors

Two timeline requirements that apply to all types of deferred exchanges:

1. 45 Day Identification Period: Replacement property must be identified within 45 days after the closing of the sale of the initial property.
2. 180 Day Replacement Period: The replacement property must be received within 180 days of the closing of the sale of the relinquished property.

Note: Extended Identification Periods: Generally, there are no extensions if you miss either of these time periods. However, for 2023 there is an exception for some taxpayers. Due to severe CA storms and flooding, taxpayers in certain California counties have more time to complete their exchanges.

• 45 Day Identification Period Extension: Taxpayers that began their exchanges between November 24, 2022, and January 8, 2023, can extend their 45 Day identification deadline to the late of October 16, 2023, or 120 days after the original 45-Day deadline.
  • 180-Day Replacement Period Extension: Taxpayers that began their exchanges between November 24, 2022, and January 8, 2023, can extend their 180 Day identification deadline to the late of October 16, 2023, or 120 days after the original 180-Day deadline.

• Value of Replacement Property: If a 100% deferred exchange is the goal, it is important that the replacement property has a fair market value equal or greater to that of the relinquished property.
• Multiple Properties Relinquished: If two or more properties are transferred on different dates as part of the exchange, the identification period and replacement period begins on the date that the first property is transferred.
• Multiple Properties Identified: More than one property may be identified as the replacement property. However, there is a limit regardless of the number of properties relinquished:
  • Three properties may be identified without regard to the fair market value of the properties.
  • Any number of properties may be identified if the aggregate fair market value of the properties is less than 200% of the aggregated fair market value of the properties relinquished.
• Boot: When the taxpayer receives other property not qualifying for like-kind exchange treatment or cash in from the exchange, then the taxpayer must recognize gain to the extent of the boot received.
  • If the replacement property value is less than that of the relinquished property, the exchange will generate taxable boot.
  • Paying too many prorates through escrow can create boot. These are expenses on the property that would have to be paid regardless of the sale. Think repairs, maintenance, utilities, association dues, property taxes, etc.). Be careful when paying normal operating expenses through escrow funds during a 1031 exchange transaction.

Types of Real Estate Exchanges

Deferred Exchange

This is the most common type of exchange in which the sale of the relinquished property occurs first and the proceeds are then directed to close the sale of the replacement property.

Reverse Exchange

Replacement property is acquired before transferring the old, relinquished property.

1. Taxpayers can achieve like-kind exchange deferred tax treatment by “parking” the replacement property with a qualified intermediary until relinquished property can be transferred to the other party to the exchange.
   
2. The timelines are the same, just in reverse. Meaning the 45-day identification period starts when the replacement property is sold, and the 180-day identification period is the time allowed to close the sale of the relinquished property.

Build-to-Suit Exchange: Sometimes called a Construction or Improvement Exchange

With this type of exchange, the proceeds from the relinquished property are used not only to purchase the replacement property, but also to make improvements to the acquired property. The exchange can be structured as a deferred or a reverse exchange.

Drop and Swap 1031 Exchange

This type of exchange is commonly used by taxpayers within a partnership when not all partners want to exchange into a new property. The partners convert their interests in the property to a tenancy-in-common and then the partner or partners that want to can cash out their interest and the remaining partners can move forward with a 1031 exchange.

• Swap and Drop 1031 Exchange: As the name suggests, this is the opposite of a drop and sway exchange in which all partners complete the 1031 exchange and the conversion to a tenancy in common and buy out of any partners is completed at a late date.  
• Planning: It is important to keep in mind that when completing a like-kind exchange, the ownership of the relinquished property and the replacement property should be unchanged. Any changes to the ownership structure right before an exchange are more likely to be scrutinized by the IRS. It is advisable to convert to a tenancy in common at least a year prior to your planned 1031 exchange. Always consult with a real estate expert such as a real estate CPA or real estate attorney.

Simultaneous Exchange

Property relinquished at the same time as the replacement property received. A “swap.”

• Simultaneous exchange is difficult for real property.

What is a Qualified Intermediary “QI”?

A Qualified Intermediary is a third party that facilitates the like-kind exchange. The taxpayer enters into a written agreement with the intermediary. The qualified intermediary then acquires the relinquished property from the taxpayer, transfers the property to the buyer, acquires the replacement property, and finally transfers the replacement property to the taxpayer.

The use of a qualified intermediary reduces the complexity of complying with Sec 1031 requirements by assuring proper documentation preparation and execution.

Common Mistakes Made by Business Owners and Real Estate Investors

• Not adhering to the deadlines for the identification and replacement periods.
• Not hiring the right qualified intermediary to facilitate the transaction.
• Buying a replacement property that does not have a fair market value that is equal to or greater than the relinquished property.
• Not working with a tax professional with sufficient real estate taxation experience as you plan and complete a like-kind exchange.

Why You Need a Real Estate CPA to Utilize Like-Kind Exchanges

Whether you are a business owner or real estate investor, like-kind exchange rules can be utilized to reinvest otherwise taxable gains into qualifying like-kind properties. As you can see, the requirements can be complicated, but a successful like-kind exchange can be well worth the extra work required. The most important part of a properly executed a 1031 exchange is planning. You need a real estate tax expert on your team that can help you make sound informed decisions and strategize around any complexities.