What is a 1031 Exchange?

Section 1031 of the US Internal Revenue Code (IRC) allows for an exchange of one investment property, often real estate, for another similar property without recognizing the capital gain from selling the property.

Section 1031 is commonly used to defer capital gains taxes in real estate. This exchange allows the investor to reinvest gross proceeds from a sale into a new property, which facilitates portfolio growth. For example, if an investor were to sell a property for $500,000 with the intention of using the proceeds to purchase a new investment property, after taxes —which can be as high as 20% for capital gains—the investor would be left with only $400,000 for reinvestment in the new property. However, with a 1031 exchange, the investor could utilize the full $500,000 for a down payment, enabling her to invest in a significantly more valuable property.

In fact, an investor reinvesting in a less valuable property would be subject to taxation on unused funds. To defer all of the capital gains taxes from the sale of a property, the down payment on the targeted property must be of equal or greater value than the value of the net proceeds received upon sale. For example, if a property is held free and clear and is sold for $500,000, but the funds are rolled over into a $400,000 property, then the $100,000 difference will either need to be rolled over into a separate acquisition or will be subject to the capital gains tax.

In another scenario, if a property is sold for $500,000, but the seller still owes $100,000 on the property, the net proceeds from sale are $400,000. These proceeds are eligible for tax deferral via a 1031 rollover. In this case, purchasing a property using at least $400,000 cash will allow investor to defer all of the capital gains tax on the cash portion. Purchasers should be wary, however, that the $100,000 of debt may still be subject to taxation.

Just as is the case with cash, the amount of leverage on the new property must be the same or higher as on the old. As a result, the newly acquired property would have to be acquired using at least $400,000 of cash and at least $100,000 of leverage in order to avoid a capital gains tax hit.

By taking advantage of 1031 exchanges, gains from one property can be rolled into another and then again into another, indefinitely deferring capital gains taxes until a property is eventually sold for cash.

Tax-deferred exchanges are nothing new. The first like-kind exchange laws came about as part of the Revenue Act of 1921. In 1954, an amendment to the Federal Tax Code brought about Section 1031 and defined the 1031 exchange more or less as we know it today. However, one significant change was made as a result of a 1967 court case, Starker v. United States. The case revolved around a land exchange in which T.J. Starker agreed to exchange a parcel of land in exchange for another property yet to be determined. Months later, Starker found a property and the exchange concluded. However, when Starker did not report a capital gain on his tax return, the IRS fined him. Starker sued the IRS for a refund and won. As a result, Section 1031 now includes provisions for delayed exchanges, sometimes called “Starker Exchanges.""

A delayed exchange requires the use of a third-party “qualified intermediary” or middle-man to hold the proceeds of the sale of the original property in escrow until a suitable replacement investment property is identified and closed.

There is, however, a strict time limit on how long the investor can wait after selling a property before they must identify and close on a new property. Within 45 days of the sale, a new property must be designated and the qualified intermediary must be notified in writing. Within 180 days of the sale, the new property must be closed so that the exchange can be completed. Waiting longer on either of those time periods disqualifies the transaction from the tax-deferral rules.

1031 exchanges offer sponsors an opportunity to present attractive property
investments that can subsequently be rolled over into larger investments,
potentially contributing to the growth and diversification of investor portfolios.

Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice. Private securities offerings may have a long holding period, be illiquid, and contain a high degree of risk. Investors must be able to afford the loss of all of their principal. Projected returns may significantly differ from actual results. Past performance does not indicate future results. Potential investors should consult with a knowledgeable tax advisor prior making an investment.

DEFINING "LIKE-KIND"
While “property [may be] exchanged solely for property of like-kind” may sound quite restrictive, the tax code provides little guidance on what the term “like-kind” actually means. In practice, especially with real estate, it can be interpreted quite broadly. “Like-kind” does not imply that properties must be of the exact same type, but rather that they must fall into the same broad class. For example, an apartment building could not be exchanged for a piece of fine art, but it could be exchanged for a tract of undeveloped land. It should be noted that while you can roll an all cash investment into a heavily leveraged one, you cannot do the opposite.

What is a 1031 Exchange?

DEFINING "LIKE-KIND"