Real Estate Articles
What the 1031 Exchange means
Rathin Neogy, MBA
When a taxpayer sells income or investment properties and buys “like-kind”
replacement properties, he uses what is called a 1031 exchange to defer paying
income taxes on the capital gains. He can keep doing this and defer taxes indefinitely.
It is extremely important to understand the basics of the 1031 process to preserve
wealth and assets. In the frequently changing world of taxation, an investor
is able to use the 1031 to build wealth through real estate investment and
maintain the hard-earned equity. This article deals with the essential things
one needs to know about what a 1031 exchange means.
Using what is called a 1031 exchange; a taxpayer is able to sell income, investment
or business property and replace it with “like-kind” property without
having to pay Federal income taxes on the transaction.
Let us now discuss what is like-kind property: any property held for investment
qualifies. This would include improved or unimproved real estate or income
producing businesses. What would not qualify is the following: a personal residence,
land being developed, speculation real estate purchased for resale, and common
stock and bonds.
Two parties, who are willing to exchange deeds of their investment property
could perform a 1031 exchange among themselves. However, this is very rare,
since typically the seller of the replacement property is not the buyer of
the relinquished property. In general, a 1031 exchange is performed by knowledgeable
and qualified intermediaries.
The general rules of a 1031 exchange are:
- Relinquished property must be an investment property
- The title to the replacement property must be taken in the same name or
names as the title of the relinquished property
- The replacement property must be like-kind
- The value of the replacement property must be higher than the value of
the relinquished property (if not, the taxpayer would have to pay capital
gains taxes on the difference referred to as “boot received.”
Types of 1031 Exchange:
There are four types of exchange: (a) Simultaneous Exchange, (b) Delayed Exchange,
(c) Reverse Ex-change and (d) Improvement Exchange.
(a) Simultaneous Exchange: It is an exchange in which the
closing of the relinquished property and the replacement property occur on
the same day — usually back-to-back. There is no interval of time between
the two closings.
(b) Delayed Exchange: An exchange where the replacement property
is closed on a later date than the closing of the relinquished property. The
exchange is not simultaneous or on the same day. However, there are strict
time rules to be followed. The taxpayer has to identify the replacement property
within 45 days after selling the relinquished property and the replacement
property has to be acquired within 180 days of selling the relinquished property.
(c) Reverse Exchange: Also called a Title-Holding Exchange,
this is an exchange in which the replacement property is purchased and closed
on before the relinquished property is sold. Usually the Intermediary takes
title to the replacement property and holds title until the taxpayer can find
a buyer for his relinquished property and close on the sale under an Exchange
Agreement with the Intermediary.
(d) Improvement Exchange: Also called Title-Holding Exchange,
it’s an exchange in which a taxpayer desires to acquire a property and
arrange for construction of improvements on the property before it is received
as replacement property. The improvements are usually a building on an unimproved
lot, but also include enhancements made to an already improved property in
order to create adequate value to close on the Exchange with no boot occurring.
Rules for like-kind property:
Finally, there are three basic rules regarding the acquisition of like-kind
property in a 1031 exchange. These are the 3-property rule; the 200% rule and;
the 95% rule. The 3-property rule simply means that you are limited to acquiring
three properties in the exchange regardless of their market value.
The 200% rule means that you can acquire any number of like-kind properties
as long as their aggregate value is no more than twice the value of the relinquished
properties.
The 95% rule means that you can acquire any number of replacement properties
if the fair market value of the properties actually received by the end of
the exchange period is at least 95% of the aggregate fair market value of all
the potential replacement properties identified.
In conclusion, the 1031 exchange allows an investor to accumulate and continue
to build wealth in a reverse-pyramid process as well as defer taxes indefinitely.
Because of the complexities and rules of the 1031 exchange, it is always best
to use a very experienced accountant as well as a knowledgeable and reputable
intermediary to conduct the process.
Note: The opinions expressed in this article are those of the author and do
not represent those of the Sterling Real Estate company.
The article is written by:
Rathin Neogy, MBA
Broker-Associate
The Sterling Real Estate Company
