A 1031 Exchange is a greatly valued strategy that allows investors to exchange their property for a better one while deferring the tax payments. If you’re doing it for the first time, it may seem confusing. You probably have a lot of questions or misconceptions about a 1031 exchange. We have created this page to answer all your questions and to address any misconceptions.
Basic FAQ’s
Who can participate in a 1031 exchange?
Anyone (be it an individual, trust, LLC, or partnership) who owns any investment or business property can participate in a 1031 exchange.
How does a 1031 exchange happen?
To do a 1031 Exchange requires an investor to work with a facilitator to get things started. Next, the investor must identify a like-kind property and purchase it while informing the IRS of the transaction (to avoid any penalties or gets taxed on the new purchase).
What is the timing of a 1031 exchange?
An investor has 45 days from the date they close on their relinquished property to identify a replacement property. During that time they may identify three or more replacement properties (so long as the total value does not exceed 200% of their relinquished property). Once the replacement properties have been identified, the investor has 180 days from the date they close on their relinquished property to close on their replacement property.
This chart should help you better understand the timeline of a 1031 exchange:
Property FAQ’s
What types of properties can I exchange into?
Section 1031 of the IRS Code allows owners of investment property to exchange it for a “like-kind” property. In this case, it could be from an apartment to an apartment, or from an apartment into any other types of investment real estate including retail, office, industrial, land, self-storage, or senior housing.
What defines “like-kind property“?
In regards to a 1031 exchange, like-kind property refers to all real property that is for investment or business purposes. For example; you can exchange an apartment complex for retail space as they are used for business purposes.
How long must I hold my current property in order for it to qualify for a 1031 Exchange?
The property involved in a 1031 Exchange must be held for “investment or productive use in a trade or a business.” When looking at “investment intent” the courts will often look to the period of time over which the property is held. That said, there is no specific holding period requirement for either the relinquished or replacement property.
Taxpayers who hold their relinquished property for two years satisfy the requisite intent for a 1031 Exchange (or two tax reporting periods). A holding period of over a year has generally been accepted, but may be subject to review by the IRS. A much shorter holding period has been accepted, where a change in circumstances indicates that the taxpayer had intended to hold the property for a longer period. The IRS will look at ‘investment intent’ and will call a taxpayer quickly flipping property a ‘dealer’ vs. an ‘investor’.
Sale and Financial FAQ’s
What are the reasons anyone would participate in a 1031 exchange?
These are some of the reasons why you would want to do a 1031 exchange:
Increased Cash Flow: Property values in some regions have appreciated considerably in recent years and the increase in property values has outpaced the increase in rents for most properties. By selling at a low capitalization rate and buying a replacement property at a higher capitalization rate, you can increase your income substantially.
Secure and Stable Income Stream: Single-tenant properties are popular investments for exchange buyers because they have long-term leases that provide stable income. The tenants are financially stable companies and the income stream has a high level of security. Additionally, most leases have fixed rent increases, providing a hedge against inflation.
Reduced Management Responsibilities: Most single-tenant properties have leases with an absolute net or triple net expense basis. Under the terms of an absolute net lease, the tenant pays for all operating expenses (such as real estate taxes, property insurance, maintenance, utilities, and replacement of all structural items). Triple net leases have limited landlord responsibilities; often, the landlord is only responsible for the repair and replacement of the building structure, roof, and parking lot.
Portfolio Diversity: Many investors have built their portfolios by purchasing one type of property in one geographic area. Performing a tax-deferred exchange provides a way to diversify your portfolio by purchasing a different property type in a different area. Single-tenant net-leased properties require very little management, making it possible to purchase properties in a different market without the need to travel frequently or hire a management company.
Do I need to sell my property first?
No, you do not. You can purchase your exchange property and sell the relinquished property within 180 days after the close of your purchase. This is commonly referred to as a reverse exchange.
What are some common exchanges?
While there are a multitude of options for an exchange, some of the more common that we work with are exchanges from a smaller apartment building into a larger building to achieve better economies of scale. A second common type of exchange, as illustrated in the case study (see 1031 Exchange tab), is an exchange into a single-tenant retail property also known as a “triple net”. A Triple Net property has virtually no management responsibilities and no expenses. The tenant pays property tax, insurance, utilities, and maintenance. This is a great fit for someone who is looking to simplify their lives or diversify their real estate portfolio.
Is 1031 only for capital gains?
Section 1031 applies to capital gains taxes (15%), depreciation recapture (25%), and state income taxes (generally 8% to 9% where applicable). Long-term capital gains taxes apply to property held over 1 year – gains from property held less than a year are typically taxed as ordinary income. Consult your accountant or tax advisor for details.
Reach out to us if you don’t see the answer to your question or would like additional information about 1031 exchanges.