A 1031 exchange is a strategy deployed, primarily by real estate investors, to defer payment of capital gains on the sale of real property by re-investing 100% of the equity proceeds back into a new property. The framework for taxpayers to defer capital gains through the sale and subsequent reinvestment of proceeds is dictated by the Internal Revenue Code (IRC) Section 1031, hence the term “1031 Exchange.”
Who can execute a 1031 exchange?
Almost any form of entity or individual can execute a 1031 exchange, but the taxpayer must remain the same before and after the exchange. For example, let’s assume that XYZ Real Estate LLC owns an apartment building that it bought for $5mm. If XYZ Real Estate LLC sells the building, it cannot dissolve XYZ Real Estate LLC and then form a new entity with which to purchase the replacement property.
XYZ Real Estate LLC must be the same entity that sells and then purchases the replacement property. If the legal entity were to change, then, the Internal Revenue Service (IRS) would not be able track who ultimately owes the capital gains tax when the replacement property is sold. For example, let’s assume that XYZ Real Estate LLC sells its apartment building for $10mm and then buys a land parcel for $12mm.
Now, let’s assume that two years down the line, XYZ Real Estate LLC sells the land parcel for $15mm. Since a 1031 defers a capital gain (instead of eliminating), XYZ Real Estate LLC will then owe taxes to the IRS based on the capital gains realized at that point. However, if XYZ Real Estate LLC was dissolved prior to the land parcel purchase, the IRS would not be able to properly track who owes the ultimate tax bill.
This brings up an important point. If the taxpaying entity must remain the same, then, the underlying owners of the entity must cooperate with each other in order to execute a 1031. For example, if XYZ Real Estate LLC is owned by 20 individuals, then, all 20 individuals need to agree to do the 1031. If 5 of the owners do not want to do the 1031 and would rather cash out, then, the other 15 owners would need to find a way to buy out the interests of the 5 owners not wishing to do the 1031.
How to calculate basis in a 1031 exchange?
When a property is exchanged into a replacement property as part of a 1031, the basis from the original property carries over to the new property. In our above example, we said that XYZ Real Estate LLC bought an apartment building for $5mm, sold it for $10mm, and then, purchased (exchanged into) a land parcel for $12mm.
The basis in the apartment building is $5mm. If XYZ Real Estate LLC were to have simply sold the property for $10mm, it would have realized $5mm in capital gains and would have owned capital gains tax on that amount to the IRS. With a 1031, this $5mm gain is not eliminated. Instead, it is deferred until the sale of the replacement property.
In this example, if the land parcel was purchased for $12mm, the basis will not be $12mm (as it would be in a normal transaction). Instead, the basis will be the original basis of $5mm plus the $2mm of new money invested. Therefore, the new basis in the land is $7mm. If XYZ Real Estate LLC were to sell the land for $12mm, then, they would still realize the $5mm in capital gains that was created during their apartment ownership.
What can be exchanged in a 1031?
The IRS allows like for like property to be exchanged under Section 1031. Almost all type of real estate will be considered like for like. Therefore, an apartment building can be exchanged for an office building, a land parcel, a hotel, a warehouse, a retail shopping center, etc.
However, real estate (real property) is not considered like for like with personal property, so personal property, such as furniture, cannot be part of the 1031 exchange. The other nuance is that the real estate that is part of a 1031 exchange must be real estate that is held for investment purposes. Therefore, real estate held for personal purposes, such as a primary residence or vacation home, cannot be part of a 1031.
Also, real estate is not considered like for like with an ownership stake in a legal entity that owns real estate. For example, if XYZ Real Estate LLC sells their apartment building for $10mm, they cannot exchange this into a 20% ownership stake in another company that owns a shopping mall because. Instead, XYZ Real Estate LLC must own the real estate directly.
What are the mechanics behind how a 1031 exchange is actually executed?
When a taxpayer wants to exchange an existing property into a replacement property, below is the general process that is followed. We will build on our example of XYZ Real Estate LLC from earlier in the article.
XYZ Real Estate LLC markets their apartment building for sale
XYZ Real Estate LLC enters into a contract to sell their apartment building to a buyer for $10mm
XYZ Real Estate LLC hires a 1031 intermediary to handle the 1031 exchange process. There are numerous specialized 1031 intermediaries that focus on the execution of 1031s for clients. The 1031 intermediary will handle the paperwork and will hold the sale proceeds in escrow while a replacement property is found
Once XYZ Real Estate LLC closes on the sale of their apartment building, the $10mm in sales proceeds will be held in escrow by the 1031 intermediary. Importantly, the seller (XYZ) cannot touch the funds in escrow. Any receipt of 1031 money from escrow will be considered a taxable gain by the IRS
Once the apartment building sale closes, XYZ Real Estate LLC has 45 days to identify 3 replacement properties that it could potentially purchase as the replacement property for the apartment building. XYZ must identify these 3 properties in writing and submit this to the 1031 intermediary, who will keep a record of this form. There are nuances to the property identification (such as identifying 6 properties), which we will not cover
From the time XYZ closes on the sale of the apartment building, XYZ has 180 days to close on one of the 3 properties identifies in their identification form (135 days from the end of 45 day identification period)
Let’s assume that XYZ Real Estate LLC identifies three properties: 1) $12mm land parcel, 2) $15mm office building, 3) $20mm hotel
Within 180 days, XYZ must close on one of these three properties. Let’s assume that XYZ is successful in closing on the land parcel within 180 days
Prior to closing on the $12mm land parcel, the 1031 intermediary will wire the $10mm in exchange proceeds to the escrow company handling the land parcel transaction. XYZ will fund the remaining $2mm
You may have noticed that in the property identification (step 7 above), we identified three properties that were all greater in size than the apartment building. Generally speaking, the IRS requires an investor to reinvest all proceeds from their sale into the 1031 replacement property. If XYZ Real Estate LLC were to sell their $10mm apartment building and purchase a $9mm land parcel, then, the $1mm in proceeds that is not reinvested will be considered taxable gain.
This is further complicated by the amount of loan that the investor uses when purchasing the replacement property. Since all proceeds need to be reinvested, the property must be big enough to accommodate both the sale proceeds and the loan proceeds that the investor wishes to use. For example, if XYZ were to purchase the $12mm land parcel with $10mm of exchange proceeds and a $5mm loan, then, XYZ would be looking at a $3mm taxable gain.
The land parcel purchase price of $12mm less the $5mm loan leaves $7mm of capacity for exchange proceeds. Since there are $10mm in exchange proceeds, there will be $3mm in exchange proceeds left over, which will be returned to XYZ Real Estate LLC. The receipt of this $3mm in exchange proceeds will be considered taxable gain.
Section 1031 exchanges are complicated, and there are numerous nuances and strict rules that investors must adhere to. Most importantly, an investor must find an attractive replacement property that they can actually close on, which is no small task. But when used properly, successful real estate investors are able to use the Section 1031 code to defer capital gains on their real estate investments for extended periods of time.