Some of my estate planning clients own highly appreciated investment properties, but few are familiar with the effective tax deferral and estate planning strategy available with the IRC Section 1031 “like kind” exchange. It can help you defer capital gains taxes on certain appreciated property indefinitely, and even eliminate them permanently. This blog post will give you a high level introduction to 1031 exchanges. If you are considering a 1031 exchange or have questions about this type of real estate transaction, please call our office for assistance.
Types of Exchanges
Real estate investors can structure their exchanges in any of the following ways, but with all exchanges, proper planning in needed so you can employ the right team to assist you .
- Simultaneous Exchange: In this type of exchange, an investor's current property is sold and the replacement property is acquired on the same day. Because of the tight timeframe, this type of exchange is now rare.
- Delayed Exchange: the most common type of exchange, the delayed exchange allows investors to sell theirproperpty and then acquire their replacement property(ies) within 180 days of close of escrow.
- Reverse Exchange: this type of exchange allows investors to acquire replacement property prior to selling the property they currently own. However, because the IRC doesn't allow the investor to be on title on both properties at the same time, the investor will need to employ an exchange accommodator to be on title to one of the two properties involved in the exchange.
- Construction/Improvement Exchange: this type of exchange allows investors to use exchange proceeds to build on land or improve an existing property. The caveat, however, is that all exchange proceeds need to be spent within 180 days of the exchange. Because most construction/improvements cannot be completed within that timeframe, this type of exchange is very rare.
A real estate property will qualify for a Section 1031 exchange if it has been held for productive use in trade or business (e.g., farmland or commercial space) or for investment (i.e., rental property that has been rented out for 1-2 years). Unfortunately, you cannot exchange your primary residence.
The properties involved in a 1031 exchange must also be "like kind." If you own an office building, you don't need to replace it with another office building. You can, for example, sell an office building and purchase 2 rental properties. As long as those properties are business or investment properties and are located in the United States, then the property is eligible for exchange. Note: you cannot sell property in the United States and replace it with property outside the United States. Further, "quick flips" are not exchangeable. Quick flips are considered "inventory" (i.e., you buy with the intent to re-sell).
Question 1: Does my 2nd home on the coast qualify for a 1031 exchange?
Answer: If you have never rented it out, then it is ineligible for a 1031 exchange. However, if you would like your 2nd home to be eligible for a 1031 exchange, then you need to make it an investment property (i.e., rent it out collecting fair market value rent for at least 1-2 years before selling it).
Question 2: I want to jump on the "tiny home" bandwagon and sell my rental property to purchase 5-10 manufactured homes. Is this an eligible 1031 exchange?
Answer: No, unless they have a foundation, manufactured homes are considered personal property, not real property, and are ineligible for a 1031 exchange.
Tax Deferral Requirements
To defer 100% of the capital gain tax liability, two requirements must be met: (1) reinvest ALL cash that was generated from the sale of your existing property; and (2) purchase a replacement property equal or greater in value to the net sale price of the relinquished property. Net sale price = sale price less non-recurring closing costs.
Question 3: I'm selling my rental property in San Francisco for $1.1 million, but it has a mortgage of $700k. How much do I need to spend on my replacement property?
Answer: If you're selling your rental property for $1.1 million and you have roughly $100K in commission and closing costs, then your net sale price is $1 million ($1.1 million - $100k). With $700k in mortgage debt (which will be paid off at the close of escrow), you will have $300k in cash ($1,000,000 - $700,000). In order to defer the capital gain tax liability, you need to (1) reinvest the $300k cash proceeds as your downpayment on your (2) replacement property that is at least $1 million or more. Because you have only $300k in cash from the sale, you will need to come up with the remaining $700k from your other assets or another home loan to purchase the replacement property.
Question 4: Can I sell my rental property in San Francisco for $1.1 million and purchase 2 or more properties in another state?
Answer: Yes, you can do multi-property exchanges as long as you are (1) investing all of your cash and (2) you're buying enough real estate that is equal or greater in value to the net sale price of the relinquished property! If your net sale price is $1 million, you can purchase one property in Nevada for $600k and another property in Utah for $500k. Note that the two properties' combined purchase price is greater in value to the net sale price of the San Francisco property.
Question 5: I found the perfect replacement property, but it's less than the net sale price of the relinquished property. What happens? Does this disqualify my 1031 exchange?
Answer: No, it does not disqualify your 1031 exchange. You can do a partial exchange where you trade down in value and you'll pay taxes on the trade down difference. In your example, if your net sale price is $1 million and you find a replacement property that is $850k, you'll pay taxes on the difference ($150k), not the entire transaction. Other options available to you: purchase an additional replacement property for $150k or more or use $150k (tax free) to improve the newly acquired property.
1031 Exchange Timeline
In a normal delayed exchange (which is the most common type of 1031 exchange), you have 180 days upon the close of escrow of the relinquished property to purchase and close on your replacement property(ies). Within the 180 days timeframe, you need to identify all of the properties you're considering buying on day 45. That is, you need to complete and submit an Identification Letter to the IRS on day 45 with a list of the properties you're considering buying.
There are two options for identifying all potential replacement properties on your Identification Letter: (1) 3 Property Rule; or (2) 200% Rule.
The "3 Property Rule" allows for identification of any three properties, of any price, anywhere in the United States. When you choose the "3 Property Rule," you need to buy one of the 3 properties listed. If you cannot close on any of the 3 properties you've listed within the 180 days, then your 1031 exchange is disqualified and you'll need to pay capital gains tax on the sale of your relinquished property.
The "200% Rule" is an option for identifying more than three properties. With this option, four or more properties can be identified, However, the combined value of all properties cannot exceed 200% of the property sold.