1031 Like-Kind Exchanges

 
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The gain, or earnings from the sale of a property are usually taxed at the time of the sale.[1] However, a 1031 Like-Kind Exchange provides an exception. It postpones the taxation on the earnings, if it is reinvested in a similar and qualified property, and it only applies to business and investment properties.[1] A 1031 Exchange is important to a property investor because he has more cash on-hand to immediately reinvest into another property since the taxes on the gain from the sale of his initial property have been postponed to a later date, or deferred[2]. Because quality and grade are not factors for Like-Kind Exchanges, the investor has the potential to upgrade his property portfolio without having to pay immediate or additional taxes.

Why is it Important?

Under a 1031 Like-Kind Exchange, when two or more properties are exchanged, the investment is still considered the same, just in a different form (e.g. a vacant lot exchanged for an office building).[3] In the government’s eyes, since the investor is just switching the form of his investment, the investor has not gained any additional earnings to pay taxes. This is when the 1031 Exchange comes into play. By postponing the tax, the investor has more money on-hand to immediately reinvest into another property. Basically, a 1031 Exchange acts as an interest free loan from the government in the amount that would have been taxed otherwise.[3] Although the gain may be immediately tax-free, it can be taxed at a later date.

Example

  • An investor purchases an office building for $100,000. After 8 years, he decides to sell the property for $175,000 to purchase a strip mall. This sale would result in a $75,000 gain from his initial purchase. If the investor purchases the strip mall with the entire $175,000, his gain ($75,000) will not be taxed. Depending on his income and tax bracket, he would save between $7,500 and $26,000. In essence, the investor is using the full gain on the sale of his office building, while saving the taxes he would have paid on his gain.

Requirements for an Exchange

When considering a 1031 Exchange, the properties (real or personal) being considered and exchanged must meet certain requirements.

  • The Property being exchanged must be used in a trade or business or for investment purposes, such as office buildings, vacant lots, and apartment buildings. Personal or vacation homes do not qualify under these requirements.[1] Other types of property that do not qualify for Exchanges are stocks, bonds, notes, or other securities or debt, partnership interests, inventories, or properties held primarily for sale (because it implies that it will not be used for business or investment purposes).[3] In addition, the replacement property must be of equal or greater value than the initial property. The equity and debt (i.e. in the form of a mortgage) must also be of equal or greater value than the initial property. Lastly, the entire gain from the sale of the initial property must be reinvested to acquire the replacement property.
  • Like-Kind means that the properties are of the same character or class to be used for investment purposes or for productive use, like in a trade or business.[4] The properties being exchanged must be considered ‘like-kind’. In most cases, real property is considered like-kind to other real property—quality and grade are not factors. For this reason, an investor can ‘upgrade’ his portfolio by exchanging a vacant lot for an office building or strip mall, without paying additional taxes to acquire the property. Exceptions are that real property within the U.S. is not considered like-kind to property outside of the U.S. and real property is never considered like-kind to personal property.[1]
  • Exchange is an integral part of the entire 1031 process. The initial property must be exchanged for a like-kind property (something given, something received)[5], and not just sold to gain cash in order to buy another property. The exchange ends as soon as the investor has control over the gain from the sale of the initial property.[3]

Although a Qualified Intermediary (QI) is not required, one is commonly used to facilitate an Exchange. A QI is an independent party established by Treasury Regulations to facilitate the exchange of properties. The importance of the QI is to help ensure that the investor can still meet the exchange requirement because the exchange is over as soon as the investor comes into control of the gains from the sale of his initial property.[3] The role of the QI is to first acquire the investor's initial property and sell it to a buyer to exchange with. The QI then holds the gains from the sale so that the investor does not come into control of the earnings before exchanging properties (which would automatically disqualify him from the Exchange). Finally, the QI purchases the replacement property and proceeds to transfer the property to the original investor.

Types of 1031 Exchanges

1031 Exchanges apply to both real (realty, specifically business and investment) and personal property. The five types of exchanges are described below.

  • A Simultaneous Exchange is when the exchange of one property for another happens at the same time. This is the simplest type of Exchange.[3]
  • A Delayed Exchange is the most common type of Exchange because it is flexible. A Delayed Exchange is when there is a time gap between the exchange of the properties(the properties are not exchanged simultaneously). The investor must follow strict deadlines when exchanging properties, or else the entire gain is taxable.[1]
  • A Reverse Exchange is the most complex type of Exchange. In this case, the replacement property is acquired before the initial property is sold, which is known as parking. The investor then has a 180 day window to sell his initial property to complete the exchange.[1]
  • A Build-To-Suit Exchange allows the investor to build-on or make improvements to the replacement property using the gain from the exchange.[3]
  • A Personal Property Exchange is when 'like-kind' personal property is exchanged. Personal and real property are never considered 'like-kind' to each other.[3]

Timeline to Execute a 1031 Exchange

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Illustrates the timeline to execute a 1031 Exchange after the date of initial sale of the property.[4]

Even though a 1031 Exchange does not have to be a simultaneous property swap, the investor must meet two deadlines within 45 and 180 days of the sale of his property. If the investor does not meet both of these deadlines, the entire gain from the sale is taxable.

  • Within 45 Days of Initial Sale: Identify potential replacement properties. A description, like an address, of the replacement properties must be in writing, signed, and delivered to the potential seller of the replacement property or a Qualified Intermediary.[1]
  • Within 180 Days of Initial Sale: The replacement property must be received. The replacement property must be substantially the same as the properties described within the 45-day limit.[1]

Sources of Data

  1. 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 Exchanges Under IRC Code Section 1031, Feb. 18, 2008
  2. MoneyChimp- Tax Deferred
  3. 3.0 3.1 3.2 3.3 3.4 3.5 3.6 3.7 Federation of Exchange Accomodators: FAQ
  4. 4.0 4.1 1031 Exchange Made Simple: FAQs, 2007
  5. Equity Advantage: Exchange Cornerstones
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