The basic concept of a 1031 exchange
In a traditional sale of property, a seller is required to pay capital gains taxes on any gain realized in the sale. One way to avoid paying capital gains taxes is to defer payment by entering into a IRC Section 1031 Exchange. As the name implies, a 1031 Exchange contemplates an “exchange” of like-kind property instead of a traditional sale. 1031 exchange rules and guidelines must be closely followed from start to finish in order for a 1031 exchange to be valid. Requirements may vary depending on whether you’re selling residential or commercial property, the state in which you live, and the timeline of when the property is sold.
Although there are many guidelines to be followed, the primary 1031 exchange rules and requirements are:
The tax return and name appearing on the title of the property that sells must be the tax return and titleholder that buys. A single member limited liability company (SMLLC) is considered a pass through to the member. Consequently, the SMLLC may sell and the member may purchase in their individual name.
Property Identification Timeline
Post-closing of the first property, the Exchangor has 45 calendar days to identify to either the accommodator or the closing entity the addresses (preferably 3 properties) of potential replacement properties. In a reverse exchange where either the replacement or relinquished, property is parked, the Exchangor has 45 days to submit a final list of properties for sale or purchase.
- Three property rule – can identify any three properties regardless of value.
- Two hundred percent rule – can identify four or more properties as long as the value does not exceed 200 percent of the property sold.
- 95-percent exception rule – if the value exceeds 200 percent, then 95 percent of what is identified must be purchased.
Within 180 calendar days following the closing of the first property–or extension of the Exchangor’s tax return when the relinquished property closes after October 15th— the property must be purchased.
The net sales price of the property sold must be equal to or greater in the replacement property to defer 100 percent of the tax. Otherwise, the Exchangor needs to pay tax on the difference, known as a partial exchange. Debt and equity in the replacement property must be equal to or greater than the debt and equity in the relinquished property. Additional equity or cash in the replacement property offsets debt. Additional debt does not offset equity.
In the seemingly complex world of 1031 exchanges, sometimes it helps to hear how others have navigated their exchange. In the following example, we follow a basic transaction that represents the general sequence from start to finish. This example is purely for relatability purposes and was kept simple with the intention of showing a common scenario. Every 1031 exchange is unique; however, there are common guidelines that must be followed in order to successfully execute the transaction from start to finish.
Jon and Judy Smith purchased a rental property in Ventura, California in February of 2016 for $350,000. They held this property and rented it out from the time they purchased it up until they put it on the market in March of 2019. With a confirmed sales contract for $475,000, they knew they would have a significant taxable obligation.
As soon as they began working with their Realtor Mary Layman, she mentioned to them that they should consider a 1031 exchange as the Smith’s intent was to sell their Ventura rental property to acquire a condo near the beach in Carpinteria that would also serve as an income generating rental property. After conferring with their CPA they decided that a 1031 would be in their best interest and that the deferral of the capital gain and depreciation recapture due would be worthwhile based on their intent to reinvest in a more appropriate investment property.
After discussing their usage of the property with a Qualified Intermediary, they determined their property was 1031 eligible. In this conversation, they discussed the amount of time they rented the property as well as the fact that they had owned the property for more than two years prior to the sale, the Smiths satisfied the IRS criteria in Rev. Proc 2008-16 and therefore their property was 1031 eligible.
In advance of the closing date, the Smiths connected their Qualified Intermediary with the Escrow Title Agent who would be handling the closing of their Carpinteria property. During this time, they continued to search for potential replacement properties with their Realtor Mary Layman so as to give themselves the most time to review potential replacement property options.
Once their property closed on May 1, 2019, two concurrent schedules began. First, the 45-day identification period, or the period in which the Smiths were able to identify the properties that they intended to acquire. Secondly, their 180-day exchange period began when the old property closed; this is the timeframe to close on the property identified during their 45-day period. Based on the closing statement, the Smiths, along with their Qualified Intermediary, were able to determine the amount that would need to be reinvested into their replacement property in order to maximize their deferral and ensure that their taxable obligation would not come due.
With a sales price of $475,000 and closing costs of $20,000, the net sales price of their relinquished property equated to $455,000.00. They had a $100,000 mortgage on their relinquished property that was paid off at closing; however, both the debt and equity (exchange proceeds) need to be reinvested in their replacement property. In the Smiths’ case, they need to reinvest the $100,000 in debt and the $355,000 of exchange proceeds into their replacement property. With this figure solidified, they began to focus on a group of homes that were equal or greater than $455,000.
After a month of vetting possible replacement properties, the Smiths extended an offer on the home they felt was their first choice. As the 45-day ID window of June 15th drew close, their QI encouraged them to add a second property as a contingency just in case there was an issue with their first choice. On June 12th, the Smiths submitted their ID letter with both choices included and indicated that they would only be acquiring one of the properties. In doing so, they submitted their ID letter ahead of the 45-day deadline and met the IRS requirement.
On July 20th, they were surprised when their first-choice home unfortunately did not pass inspection and they were not able to move forward with it. Thankfully, they had identified a second property and immediately reached out to the listing agent. Within 48 hours, Mary Layman submitted a contract on the property at the listing price of $495,000. Had the Smiths not included a second property, they would not have been able to move forward with their exchange, as properties cannot be acquired that are not identified by the 45th calendar day.
Although, some think this may be complicated, with the right Realtor, like Mary Layman, a reputable qualified intermediary (QI) for 1031 exchange and your escrow and title company, this is a tax savings and financially beneficial way to move forward. The concept of the exchange is easy to understand, however the details involved in the exchange need careful planning. The cost to do an exchange for the QI will be in the range of $500.00-$800.00 for one property exchanged. Before taking steps towards a 1031 tax deferred exchange, please consult with your CPA, attorney or tax advisor.