Section 1031 Exchanges are a fairly unknown topic – but one that drives the world of real estate. It was estimated in a 2015 study that this hidden real estate tool adds somewhere between 7.5% and 11.6% to the value of all real estate in the United States. Considering the U.S. real estate market is worth $27.2 trillion – a topic which is worth up to $3 trillion is one that needs to be addressed. With this particularly section of the tax code under constant political attack (especially this year — more on that below), it seems timely to walk through this topic and make sure you understand the options that are available to you if you’re looking at the potential sale of real estate in the near future.
What Is a 1031 Exchange?
Let’s look at the definition first, before we break it down:
“Broadly stated, a 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meets the requirements of 1031, you’ll either have no tax or limited tax due at the time of the exchange”
Let’s decipher that in English: Normally if you sell an income producing property (i.e. a rental home, office building, farmland, etc.) and have a gain on the property, you will be responsible for paying taxes on your realized gain. Section 1031 allows you instead to use the proceeds of the sale to buy a “like-kind” replacement property and roll any gains you have into the new property without paying any taxes. Theoretically, you could (and we have seen many of you do this) constantly roll properties from one 1031 exchange to the next until you die. At that point, your heirs would receive a “step-up in basis” meaning they too would not pay any taxes. Simply put, it is a way to completely eliminate capital gains taxes on real estate assets (if it is done correctly!).
If that sounds too easy…it’s because it is.
Sadly, as with anything tax code related, it is not as simple as it sounds. There are many specific and important rules surrounding this process that require the assistance of professionals to ensure the exchange is done correctly and you are not surprised with an unexpected tax bill. For example:
There are some very specific timing requirements around a 1031 exchange which must be met and documented to ensure a capital gain is not recognized. The clock for these deadlines starts on the day you execute the sale of the previous property.
The first deadline happens on day 45. The IRS requires you to identify “potential replacement properties” within 45 days of selling your property. This deadline still offers some flexibility as you may designate up to three potential properties if you eventually close on one of them.
The second deadline happens at day 180. You must close on the replacement property no later than this date. If either of these two deadlines are missed, the property will not qualify for a 1031 exchange.
As you can imagine, 45 days can be a tight window when you are thinking about reinvesting substantial proceeds from a sale. Due to this, it is important to start thinking about a 1031 exchange before you ever close on the sale of the original property.
One of the areas that commonly causes problems in a 1031 exchange is debt on the property. Let’s run through an example to help make it clear.
- Initial Sale: $1,500,000
- Debt on Property: $1,000,000
- Proceeds: $500,000
- Replacement Purchase: $1,000,000
- Debt on Property: $500,000
- Equity in Property: $500,000
In this scenario, your equity does not change but you have essentially had $500,000 in debt “forgiven” through the 1031 exchange process. That $500,000 in reduced debt is called “boot” and is considered a taxable transaction meaning the investor in the scenario above would be taxed on the $500,000 in debt reduction noted above. That could be a big, bad surprise. A good rule of thumb for debt is “You can always go up, but you can’t go down” on the level of debt on the replacement property without paying taxes. If you end up with a lower percentage of debt on the replacement property the IRS considers this a way that you have taken money out of the transaction and thus you will need to pay taxes on that amount.
Using a Qualified Intermediary
A final – very important – key requirement of a 1031 Exchange is the use of a Qualified Intermediary (QI). A good QI can make the process seamless and relatively pain free. A bad QI can spell trouble.
Let’s understand what the QI does. They stand between you and transactions – ensuring you never actually realize the proceeds of the sale. When you sell your initial property, the proceeds do not actually go to you – they go to an escrow account controlled by the QI.
Upon the identification and purchase of the replacement property, they will be responsible for ensuring the timing deadlines, boot considerations, etc. are properly handled. This makes them a very important link in the chain. They control your funds and – to a large degree – they control the success or failure of your exchange. Surprisingly, there is no “certification” to be a QI. No license. No supervisory body. As such, ensuring you are partnering with the right QI is imperative to this process. While we do not provide QI services, we have experience doing dozens and dozens of 1031 exchanges and have worked with some very “qualified” qualified intermediaries. We would be happy to introduce you to one if necessary.
1031s Still Need to be a Good Investment!
Some 1031 exchanges are quite simple. An investor has found a new property they want and intends to sell an existing property to purchase it. The identification of the replacement property is already completed long before the sale of the initial property.
The more difficult 1031s – and the ones where Insight gets involved – come about when an investor intends to sell a property but does not have a readily available replacement property. Maybe it is a retired farmer who does not wants to sell a piece of land to his son who took over the operation. Or a business owner who is selling his business and the associated real estate.
Often these are the situations where a 1031 exchange makes the most sense. But the very tight 45-day identification window means it is often a race against the clock.
There are companies in the real estate industry who look to take advantage of that. They know investors can be desperate to find a property, so they buy properties with the intent of “warehousing” them and selling them at a mark-up specifically to the 1031 exchange market.
While this may make sense for some, it also means the investor is not getting the best deal. Those products are often so marked up and fee laden they are not good investments despite the fact it may be beneficial from a tax perspective.
We do not warehouse deals, but instead look to find what is the best available option within the time horizon or “45 day” window that you must identify. If we have more lead time on the timing of the transaction, we can look to find things with more specific characteristics to match your needs. That is where our due diligence team – led by Karlton Kleis – comes in for Insight clients. Due to their work for Arete, they have an extensive rolodex of contacts in the world of investment real estate. They are able to use their experience constructing deals and their institutional knowledge of who needs money when to help connect our 1031 exchange investors with quality investments that we would be proud to support whether a 1031 exchange was in play or not.
Time May Be of the Essence
Section 1031 of the U.S. Tax Code became law in 1954. Since that time, the specifics of the rule have changed, but the basic idea of a like-kind exchange has remained. But since about 1955, Section 1031 has been attacked by politicians who see it as a giveaway to real estate “fat cats”.
That may be true – but we have also seen Section 1031 benefit our clients significantly as well. While you are all undoubtedly successful, we do not think you are the real estate barons the politicians have in mind!
The siren song of eliminating the 1031 exchange is back in the 2020 election. Democrat nominee Joe Biden has laid out clearly in his tax policy he intends to eliminate Section 1031 for anyone with income exceeding $400,000. This could potentially be a devastating blow to the real estate industry at a time it is reeling from COVID-19.
This – combined with the Biden plan to eliminate the capital gains tax rate – means 2020 may be an important time to execute a 1031 exchange if you are considering the sale of a property.
If you are in the process of looking at a 1031 Exchange, or potentially selling a property, keep these key points in mind:
- The 45-Day identification window is tight. It is much better to identify a replacement property before you sell than waiting until after. If you do wait, you may be stuck taking the “best available” option for reinvestment instead of the right one for you.
- The level of debt you have on your existing property is important. Remember – you can always go up the debt ladder but reducing your debt may have taxable consequences.
- Find a good professional to help you before you sell your property. It is important you fully understand the risks and benefits of a 1031 and are not forced to make reactionary decisions based upon the IRS’s timetable.
As always, we stand ready to help you through the most complicated parts of your financial future. This particular area is one in which we have extensive experience. If you or someone you know has any questions about Section 1031 and how it may benefit you, we would be happy to offer assistance.