1031 Exchange

A Powerful Tax Strategy to Build Wealth

Why Consider a 1031 Exchange?

Section 1031 of the Internal Revenue Code might just be the most powerful tax strategy available to investors seeking to build wealth.  The 1031 exchange, also called a like-kind exchange or a Starker exchange, provides an effective strategy for deferring the capital gains (and often the depreciation recapture taxes*) that would otherwise be levied on the proceeds of an investment or business property sale.  Generally, most sales of real estate are taxable events, but by following the rules of Section 1031, a taxpayer can "exchange" one property for another property of like-kind and delay their tax event until a later date, deferring tax and using tax-free proceeds to purchase a replacement property.

All investors and business property owners should consider a 1031 exchange if they are disposing of an investment or business property and will be replacing it (or are willing to replace it) with another investment or business property.  To do otherwise would likely trigger taxable gain, and even though the tax paid on an investment or business real estate sale is generally lower than the ordinary income tax rate, long-term capital gains rate and depreciation recapture rates can approach 30%. 

Basic Rules of a 1031 Exchange

The rules of Section 1031 have many moving parts that real estate owners and investors must understand before attempting an exchange.  In fact, we recommend using an experienced 1031 exchange professional to facilitate the transaction.  At minimum, a qualified intermediary will be needed to hold the proceeds after you relinquish your property.  

There is no limit on how many times or how often you can use Section 1031.  You can defer tax on the sale of one property, on the sale of the next property, on the sale of the next, and so on, indefinitely until you ultimately want to "cash out."  Although you may have a gain on each exchange, this indefinite deferral allows your initial investment to grow tax-free.  This is why the 1031 exchange is such a great tool for building wealth.  

"Like-Kind" Property Types

For tax purposes, the term "like-kind" doesn't mean what most people probably assume it means.  It doesn't mean exactly, or even somewhat, alike.  A farm can be exchanged for a strip mall, a residential rental home can be exchanged for an office building, and even an industrial warehouse can be swapped for development land*.  "Like-kind" broadly means the property is an investment or business property, although there are special rules that can allow a former primary residence to be exchanged under certain circumstances.  There are also ways to use Section 1031 to swap vacation homes.  Such minute details are why a professional should be handling your 1031 exchange.

*There are special rules for exchanging depreciated property for raw land.  Generally, exchanging a depreciated building for another building will also defer the tax on the depreciation recapture.  However, since buildings are depreciable for tax purposes and land is not, exchanging a depreciated building for raw land will require the payment of tax on any depreciation previously taken on the building. 

Timing Rules

By definition, an "exchange" of property involves two people agreeing to swap properties with one another.  However, the odds of finding a property you want whose owner also wants your property is extremely slim.  Therefore, the majority of 1031 exchanges are delayed, or Starker exchanges (named after the first US. Tax Court case that allowed them).  The delay is what requires the third party, qualified intermediary to be involved.

There are two main timing rules for 1031 exchanges:

• 45-Day Rule.  The first timing rule relates to the identification of one or more "replacement properties" once the taxpayer has sold their property (the "relinquished property").  At the closing of the relinquished property, the qualified intermediary will receive the cash proceeds.  Otherwise, the receipt of cash by a taxpayer will cause the 1031 exchange to fail.  At some point during the 45 days after the closing, the taxpayer must notify the qualified intermediary, in writing, of the property or properties that might be acquired.  A taxpayer can identify up to three replacement properties as long as one is eventually purchased and closed on.  There are other more specific rules for identifying more than three, based on certain valuation tests.
• 180-Day Rule.  The second timing rule relates to the closing of the identified replacement property(ies).  The taxpayer must close on the replacement property(ies) within 180 days after the closing of the relinquished property.