The 1031 Exchange might help you defer Capital Gains Taxes on the sale of investment properties. 

Most folks would prefer to avoid paying taxes if they don’t have to. If you’re considering selling an investment property and buying another one, it might be in your best interest to consider a 1031 exchange. In this blog, I’ll attempt to demystify and explore some basics of the 1031. 

The 1031 Exchange (also known as the Starker Exchange) allows owners of investment, business, or commercial property to defer all or a portion of capital gains taxes on the boot (taxable net) from the sale and subsequent purchase of like kind investment properties. Though it won’t alleviate the tax burden indefinitely, it will defer the tax until the replacement property is sold and the seller takes constructive receipt (personal possession) of the boot. 

A 1031 exchange isn’t a literal physical exchange of property; i.e. a duplex for a duplex. In reality, it’s a financial exchange. An investor can exchange one type of property for another by taking the boot from the sale of their investment property and putting it directly into the purchase of a replacement property via a Qualified Intermediary (QI) or exchange agent. For instance, the boot from the sale of a duplex could be reinvested into a warehouse, or a strip mall. 

A QI or Exchange Agent is fundamental to the 1031 process. They will hold the boot from the sale of a relinquished property, so that the exchanger doesn’t take constructive receipt and end up responsible for the tax bill associated with the boot, then transfer the funds to the seller of the replacement property. There are companies that exist solely to service these kinds of transactions. Most title companies also offer these services. 

1031 Exchange - Only Like Kind Properties Allowed

For the purposes of the 1031 exchange, like kind property is defined as any kind of property used for investment or business purposes. It, “must be held for a productive use in a trade or business or for investment “ Note that, when an investor purchases a property for exchange, the investor’s intent is crucial. They are required to hold the property for purposes of renting, investing, or business. 

Property that does not qualify for like kind exchanges:

• Personal residences

• Property held primarily for sale; think remodels or flips for profit

• Stocks, Bonds, Notes; or other securities

• Interests in partnerships

• Personal property; cars, boats, appliances, guitars etc. 

The 1031 Exchange Process 

There is a process that must be adhered to when taking part in a 1031 exchange. This is the order of events and rules pertaining to a 1031 exchange. 

1. The exchanger consults with their tax professional as to whether or not the property is a likely candidate for 1031 
2. The exchanger signs a listing contract with a real estate broker to sell their property. The listing agreement or an addendum to it, must state the seller’s intention to participate in a 1031 exchange. 
3. The exchanger contacts a QI also known as an exchange agent, to consult and prepare 1031 documents
4. The 1031 exchange documents must be signed by the exchanger prior to the sale of the investment property 
5. Once the property to be relinquished is sold it is deeded to the buyer. The proceeds of the sale go to the QI/exchange company to hold. Both sellers and buyers must agree to assign the contract to the QI.
6. The closing date of the relinquished property begins the exchange period. The exchanger then has 45 days to identify another property.  
7. From the closing date of the relinquished property, the exchanger has 180 Days to close on replacement property. 
8. There are three rules to be aware of when engaging in the search for a 1031 exchange replacement property. 

• 3 Property Rule - The exchanger may identify up to three properties as replacements, regardless of their value. 
• 200% Rule - The exchanger may combine any number of properties as long as their  market value isn’t more than twice that of the relinquished property
• 95% Rule - Rarely used, this rule makes it allowable for the buyer to identify properties that add up to more than 200% of the relinquished property’s value (i.e. 4 or more properties), but they must purchase at least 95% of the properties they identify. 
• The replacement property cannot have been a personal residence

1. Be aware of the Mortgage Boot rule: When an exchanger owes less debt on the replacement property than the relinquished property, the difference will be taxed as income. 
2. When making an offer on a replacement property, the buyer should include notice that the property being purchased is part of a 1031. Once the new property is in contract, contact the QI will prepare the final set of exchange documents. 
3. As part of the closing process, the QI will transfer the funds to the seller, and then transfer the deed directly to the exchanger. 

Reverse 1031 Exchange  

A reverse exchange happens when an exchanger would like to acquire replacement property prior to the closing of the relinquished property.

1. The IRS won’t allow a taxpayer to hold title to a replacement property and a relinquished property at the same time
2. To circumvent the IRS rule preventing the exchanger from holding both titles, the exchange company utilizes an EAT (Exchange Accommodation TitleHolder). An EAT is  an LLC created by the exchange company to temporarily take title to the replacement property.
3. The exchanger will need funds (i.e. down payment/closing/realtor/mortgage) to buy before the sale of the relinquished property
4. The date that the EAT begins starts the 1031 exchange timeline. The exchanger then has 45 days to identify the relinquished property they’d like to sell. 
5. The exchanger has 180 days to complete the sale of the property to be relinquished and  acquire the replacement property from the EAT. 
6. The reverse 1031 exchange requires more planning than a forward 1031. It’s a good idea to contact the QI before beginning the process. 

1031 Vacation /2nd Home

Typically, 1031 exchanges apply to rentals, raw land, and commercial buildings.

However, if Safe Harbor guidelines are followed, vacation homes can be exchanged as long as they follow the 1031 guidelines and Revenue Procedure 2008-16 If a property qualifies for Safe Harbor, the IRS won’t challenge whether it’s a vacation home or an investment property. 

To qualify a vacation home for Safe Harbor protections, the exchanger must:  

• Have owned the property for two consecutive years 
• Rented the property out at fair market value for at least 14 days in a year
• The exchangers personal use in each year of the two year period is limited to 14 days in a year or 10% of the days the property was rented, whichever is greater. I.e. 10% * 200 days rented = 20 days of personal use

1031 Time Keeps On Ticking, Ticking, Ticking… Into The Future 

The 1031 exchange presents unique challenges in the form of a gauntlet of deadlines to be run by the exchanger. It can be challenging to find appropriate replacement property, or, in the case of a reverse 1031, sell the property to be relinquished to satisfy the timelines necessities. A lot of curveballs can come when inspections and appraisals enter the timeline. Negotiations can drag on. Repairs can drag on. In short, once in contract, sales can become complicated or fail for a myriad of reasons. 

Be sure to perform sufficient due diligence and have your criteria as clear as possible when performing property searches to identify potential replacement properties in time. Assemble a team of qualified professionals (tax pros, attorneys, realtors, exchange agents, title companies, appraisers, home inspectors ) to help you alleviate these pain points and guide you through a successful 1031 exchange.  

As always, I’m glad to be your resource and advocate in all of your real estate needs in Oregon and Washington. 

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Sam Densmore/Realtor/Inhabit Real Estate /September 23, 2024 All Rights Reserved