1031 Exchange Frequently Asked Questions

Q. What are the benefits of a Section 1031 tax deferred exchange?

A. 1031 tax deferred exchanges allow real estate investors to defer capital gain taxes on the sale of a property held for productive use in trade or business or for investment.  This tax savings provides many benefits including the obvious – 100% preservation of equity. Investors can take advantage of exchanges to meet other objectives including: A ) Leverage: exchanging from a high equity position or “free and clear” property into a much larger property with some financing in order to increase their return on investment.  B) Diversification: Such as exchanging into other geographical regions or diversifying by property type such as exchanging from several residential units into a retail strip center.  C) Management Relief: for example, exchanging out of multiple relinquished properties into either a replacement property like an apartment complex with an on-site manager or a tenant-in-common ownership program. Read the full article, Benefits of a 1031 Exchange.

Q. How do I calculate the capital gain taxes owed?

A. There are three steps involved in determining the capital gain taxes that are owed.  The first is to determine the net adjusted basis – this is calculated by starting with the original purchase price, adding the capital improvements and subtracting the depreciation taken.  The second step is calculating the actual capital gain by taking today’s sales price, subtracting the net adjusted basis and then subtracting the cost of sale to arrive at the capital gain.  The third, and final step, is determining the capital gain owed.  Under this formula, the recaptured depreciation is all taxed at 25% and the remaining economic gain is taxed at the maximum capital gain tax rate which is currently 15%.  Finally, the state tax rate, when applicable, is also applied to the capital gain.  All three of these amounts, the depreciation recapture, the federal amount and the state tax, are added to arrive at the total capital gain tax due. Use our, Capital Gain Tax Calculator.

Q. Why should I exchange rather than sell?

A. A 1031 exchange allows an investor to defer paying all of the capital gain taxes, which essentially equates to a long-term and interest-free loan from the Internal Revenue Service.  Since the investor who exchanges has all of their gross net equity available to reinvest, using leverage, they can acquire significantly more investment real estate that if they sold, paid all the capital gain taxes and then purchased a new a property.  The real advantage of a 1031 exchange is not just the tax savings – it is the tremendous increase in purchasing power generated by this tax savings! Read the full article, Sale versus an Exchange.

Q. What are the requirements for full tax deferral?

A. For full tax deferral, an exchanger must reinvest all of the new proceeds in “like-kind” replacement property and have the same or greater amount of debt on the replacement property or properties.  Another way of looking at this is to purchase replacement property of equal or greater value, and reinvest all of the net equity. Read the full article, Requirements for full tax deferral.

Q. Can I do a partial exchange and pay taxes on a portion of the capital gain?

A. Yes, an exchanger can do a partial exchange and not reinvest all of the net equity or take on debt in the replacement property – the property being acquired - that less than the debt in the relinquished property – the property being disposed of.  The exchanger must recognize as income the exchange proceeds received and/or the reduction of debt to the extent there is a capital gain. Read the full article, Partial Exchanges.

Q. What is “boot”?

A. Boot is any non like-kind property received by the exchanger and is taxable to the extent there is capital gain.  “Cash boot” is the receipt of exchange proceeds by the exchanger.  “Mortgage boot”, also sometimes referred to as “debt relief,” is the exchanger having less debt on the replacement property or properties that they had on their relinquished property.  Cash or mortgage boot can be offset by the exchanger adding outside cash to the replacement property purchase.  If the exchanger wants to receive cash boot, it must be received either at the closing of the relinquished property or after they have purchased all property they are entitled to under the exchange agreement- which is generally the end of the exchange period. Read the full article, What is Boot?

Q. What is a delayed exchange and what time limits are involved?

A. A delayed exchange happens when the exchanger closes on the sale of their relinquished property on one date, and then acquires a replacement property from a seller at a later date.  An exchanger has a maximum of 180 calendar days, or their tax filing date, whichever is earlier, to complete their exchange.  This is called the “exchange period”.  In addition, the exchanger must identify their potential replacement property or properties by midnight of the 45th day after closing on the sale of their relinquished property.  This is called the “identification period” and the 45 days are inclusive within the 180 day exchange period. Read the full article, The Delayed Exchange.

Q. What are the “rules of identification”?

A. Although an exchanger can identify more than one replacement property, the maximum number of properties that can be identified is limited to one of the follow three rules: 1) Three replacement properties without regard to their fair market value (the “3 Property Rule”)  2) The value does not exceed 200% of the aggregate fair value of all relinquished properties (the “200 Rule”) and 3) Any number of replacement properties without regard to the combined fair market value, as long as the properties acquired amount to at least 95% of the fair market value of all identified properties (the “95% Rule”). Read the full article, Identification Rules.

Q. What is a reverse exchange?

A. A reverse exchange is closing on the purchase of the replacement property before closing on the sale of the relinquished property.  Many investors utilize a reverse exchange to immediately acquire a desirable replacement property in a seller’s market where there may be competing offers or there is a pressing need to close quickly.  Other investors may initially set out to perform a delayed exchange, but they quickly find an ideal replacement property that must close on quickly.  In this second scenario, the exchanger avoids the pressure-filled problems associated with the 45-day identification rule. There are several different reverse exchange variations including the replacement property parked option, the relinquished property parked alternative and the reverse-improvement exchange. Read the full article, Reverse Exchanges.

Q. What is an improvement exchange?

A. The improvement exchange, sometimes referred to as a construction or build-to-suit exchange, allows an investor, through the use of a qualified intermediary, to make improvements on the replacement property using exchange equity.  The improvement exchange can often result in a better or more suitable investment property that those readily available on the open market.  The ability to refurbish, add capital improvements, or build from the ground up, while using tax deferred dollars, can create tremendous investment opportunities. Read the full article, Improvement Exchanges.

Q. What types of property can be exchanged and what is the definition of like-kind property?

A. Any property held for productive use of trade or business or for investment can be exchanged for any other property held for productive use in trade or business or for investment – these properties are considered “like-kind” to one another.  Examples of like-kind investment real estate include: exchanging unimproved for improved property; a fee interest for a leasehold with 30 or more years left; exchanging vacant raw land for a commercial building; or exchanging a single family rental for a small apartment complex.  The rules for exchanges of personal property are significantly more narrow and class or asset code specific than for real property. Read the full article, Like-Kind Property.

Q. What criteria does the IRS look at to determine if a property was held primarily for sale purposes versus being held primarily for investment purposes?

A. The exchanger should be able to substantiate that their primary intent was to hold property for investment purposes or for productive use in trade or business.  Some, but not all, of the factors that provide and indicator of the exchanger’s intent include:  A) the nature and purpose of the acquisition and the duration of ownership; B) the extent and nature of the exchangers efforts to sell the property; C) the number, extent, continuity and substantiality of sales; D) the use of a business office for the sale of property; E) the character and degree of supervision or control exercised by the exchanger over any representative selling the property and F) the time and effort the exchanger habitually devoted to sales. Read the full article, Property Held for Sale.

Q. How long does a property need to be held to be considered “held for investment”?

A. The central issue is whether or not the investor has the intent to “hold for investment”, not just the period of time.  There is no “safe” holding period to automatically qualify as being held for investment.  Time is only one of the factors the IRS can look at to determine the exchanger’s intent for both the relinquished and replacement properties.  Every investor has unique facts and circumstances and it is up to them, and their tax or legal advisors, to be able to substantiate that their primary intent was to hold property for investment purposes. Read the full article, How Long to Hold.

Q. What is a tenant-in-common (TIC) ownership and what are the benefits of these programs?

A. A tenant-in-common ownership program, often referred to as a “TIC”, is where an exchanger acquires fractional ownership in a larger commercial property with up to 35 other co-owners.  There are many benefits to TIC ownership including professional property management, geographic diversification, appreciation, predictable cash flow, depreciation and flexibility without management problems.  A properly structured TIC program should not be a joint venture or a partnership. Read the full article, Tenant-In_Common Basics.

Q. Can I exchange an LLC member interest or a partnership interest?

A. No, an LLC member interest, where the LLC elects to be treated as a partnership, or a partnership interest are considered personal property and cannot be exchanged.  IRC Section 1031(a)(2)(D) specifically prohibits the exchange of partnership interests.  However, both an LLC or partnership (or any other entity for that matter) can do a 1031 exchange on the entity level, meaning the entire partnership relinquishes a property and the entire partnerships stays intact and purchases a replacement property.  If you are in a situation where some LLC members or some partners would like to exchange, but others don’t, consult with your tax or legal advisors and discuss the issues involved with strategies and the timing of performing what are known as “drop and swap” or a “swap and drop” alternatives. In a community property states only, a husband and wife who are the sole members of a two member LLC may be considered a single member disregarded LLC for Federal tax purposes – check with your tax or legal advisors to discuss this more thoroughly. Read the full article, Partnerships and 1031 Exchanges.

Q. What should I look for when selecting a “Qualified Intermediary”?

A. There are a number of factors that should be considered before selecting a Qualified Intermediary, sometimes referred to as a “QI” to facilitate your exchange.  One of the most important is researching specific security measures they provide for the exchange proceeds held in their possession during the exchange period.  This is crucial because there is no entity at the Federal level that oversees or regulates Qualified Intermediaries and how the proceeds are invested and kept safe for investors.  In addition, find out the experience of the company, how many exchanges and the knowledge level of their staff and diversity of experience.

Q. Who do I contact to discuss my specific exchange situation?

A. Every exchanger should always review all aspects of their specific facts and circumstances with their own tax and/or legal advisors.  Although a Qualified Intermediary cannot provide specific legal or tax advice, feel free to contact Asset Preservation, Inc. for a complimentary consultation by calling toll-free either 800-282-1031 for the California headquarters or 866-394-1031 to reach our Eastern Regional office in New York.