Updated April 30, 2018
So you thought there was nothing certain but death and taxes?
Not so fast.
If you plan to sell appreciated business or investment property — a rental home or office building, for example — and replace it with similar real property, you may be able to avoid paying federal income tax until the replacement property is sold.
It’s known as a 1031 tax-deferred exchange or, sometimes, a like-kind exchange.
If you’ve invested in real estate in greater Seattle over the past few years, it’s important to understand the 1031 exchange rules. Chances are your property has appreciated, potentially dramatically. And the unfortunate side of this kind of appreciation is the tax bill.
In general terms, a 1031 exchange is a swap or trade of one business or investment property for another, subject to a number of qualifying federal tax rules. The 1031 refers to the section of the Internal Revenue Code that establishes the rules.
If your transaction(s) qualifies for 1031 treatment, you can sell one or more appreciated real properties (traditionally rental or investment real estate), reinvest the funds in another property, and defer payment of any capital gain taxes and depreciation recapture on the profit from the sale.
While individuals can qualify for a 1031 exchange, so can any taxpaying entity — including C and S corporations, partnerships, LLCs, and trusts and estates.
The General Rules for a 1031 Exchange
The federal tax code imposes a number of requirements to qualify for this favorable tax treatment, among them restrictions on the types and values of property exchanged, the timing of the exchange and the people that must be involved in the transaction(s).
Like-Kind Property Held for Business or Investment Purposes
The properties swapped in a 1031 exchange must be real property held for investment or utilized in a trade or business and they must be of like kind. Property held for personal use does not qualify.
In general, like-kind property is property of the same nature, character or class.
The classification of properties as like-kind for this purpose is based on their use and not their type, so the concept of like-kind properties is broader than you might think. The properties themselves may actually be quite different. For example, a single-family rental home can be exchanged for a parking lot, a hotel, a marina, or any number of even more exotic properties.
Through years of taxpayer-attempted 1031 exchanges, the IRS has compiled an extensive list of property exchanges that either qualify or do not qualify for 1031 treatment. A few general examples that do not qualify are:
property held primarily for resale rather than for investment purposes
a primary residence
property located outside of the United States
Properties do not have to be exchanged simultaneously. Deferred exchanges are allowed if they meet certain time limits. These time limits cannot be extended, except in the case of a presidentially declared disaster.
45 Day Identification Period You must identify the replacement property within 45 calendar days of the closing date of the sale of the old property. This identification must be specific and written and is typically made to a qualified intermediary or exchange facilitator (explained below).
You can identify up to three potential replacement properties without regard to their cost. However, identifying more than three properties subjects you to additional IRS limitations that, if not met, will disallow all of the identified properties.
180 Day Purchase Period – The replacement property identified above must be purchased and the exchange completed by the earliest of 180 days after the closing of the old property or the extended due date of the tax return for the year in which the old property was sold.
Use of a Qualified Intermediary or Exchange Facilitator
You must use a qualified intermediary for your sale and purchase transactions in order to preserve the 1031 exchange treatment. The qualified intermediary prepares essential documentation and manages the transfer of the properties as well as the related funds. This is particularly important as your 1031 exchange may be disqualified if you receive cash or other proceeds before the exchange is complete. It’s essential that you take care in selecting a qualified intermediary due to the substantial impact they can have on the success of your transaction.
Your qualified intermediary must be an independent third party. The qualified intermediary cannot have had a family relationship with you (the seller of the property), or a prior business relationship during the preceding two years. Examples of disqualifying business relationships include employee, attorney, investment banker, accountant and real estate agent or broker.
Often a 1031 exchange facilitator serves as qualified intermediary. With specialized expertise in 1031 exchanges, this person can help to ensure the exchange is in compliance with all laws, regulations and rulings.
Titling of New and Old Properties
You must take title to your new property in the same manner as you held title to the old property. In other words, the name/entity on the title of the old property (and its tax return) must be the same name/entity for the replacement property.
This can be problematic if your old property is held in a partnership, corporation or limited liability company (LLC) that is or will be liquidated.
Strategies to resolve potential titling issues require careful planning. The specific facts and circumstances are often unique, and can raise issues leading to a potential IRS challenge.
Amount Reinvested in New Property
In order to defer 100 percent of the tax on gain from the old property, the replacement property must be of equal or greater value.
Obtaining cash or other property as part of the exchange transaction will not disqualify the exchange as long as the above requirement is met. However, the IRS has specific rules related to receiving cash or paying off debt. Commonly known as boot, this could result in tax due on the net amount received.
Advantages of 1031 Exchanges
While the potential tax benefits of 1031 exchanges tend to drive their popularity, there are other advantages.
Deferral of Taxes
The clearest advantage of a 1031 exchange is the ability to defer paying taxes on the sale of a property until you dispose of the replacement property.
The thinking goes: If you intend to buy a replacement property, why pay a portion of the proceeds from selling your old property to the IRS if you don’t have to? It just reduces the funds you have at your disposal.
Future Reductions in Tax Rates
Congress can, and does, change tax rates frequently. If you anticipate that rates will be lower when you sell your replacement property, the lower rates on your gain and any depreciation recapture can provide a permanent tax benefit from a 1031 exchange.
Similarly, you might be in a lower tax bracket when you sell the replacement property — perhaps you’ve retired by then. Again, lower tax rates can provide a permanent tax benefit.
Property Management Relief
Certain property just requires more active involvement, and thus a greater investment in time and resources. If you’d prefer a property that requires less of your time to manage, you could use a 1031 exchange to obtain a lower maintenance replacement property.
There is a time value to money. The longer you have ownership of funds and earn a return on them, the more your balance grows. It’s similar to the concept behind tax-advantaged retirement accounts. In this case, by deferring taxes, the full amount of your gain continues to earn a return for you until you sell your replacement property.
Disadvantages of 1031 Exchanges
As you read through the requirements for a 1031 exchange, you may have thought No Problem. But just because you can qualify for 1031 exchange treatment doesn’t mean you should proceed with a 1031 exchange. It’s important to factor in the potential downsides before you make a final decision.
Strict Procedures, Rules and Regulations
Complying with the requirements noted above and dealing with the strict timeline for identifying and acquiring the replacement property may not be an easy task depending on your specific circumstances.
Reduced Basis of Property Acquired
A 1031 exchange only defers your taxes until you sell your replacement property. If you only plan to hold the property for a short period of time, the tax benefit from the deferral will be limited.
Future Increases in Tax Rates
As noted above, Congress can change (in this case, increase) tax rates or you may move into a higher tax bracket. Sometimes locking in a current tax rate is preferable to subjecting yourself to an unknown future rate. The 2013 increase in the maximum capital gains tax rate from 15 percent to 20 percent is a great example.
Don’t get caught up in the details of a 1031 exchange.