1031 Exchange Explained
The 1031 Exchange is an excellent tool for investors that are looking to use the funds from the sale of an investment property to buy another, like-kind investment property of equal of greater value.There are several types of 1031 Exchanges. Listed below are the five most common types of 1031 Exchanges followed by a detailed description of the 1031 Forward Exchange as explained by Marty E. from our 1031 Exchange Accommodator.
1. Forward Exchange
Section 1031 Forward Exchange, allows an investor of appreciated real estate to sell and transfer all of the gains from one property to another property or properties with the use of an intermediary which allows the seller to defer the tax. The properties exchanged must be held for productive use in a trade or business, or for investment.
2. Reverse Exchange
The Internal Revenue Service issued Revenue Procedure 2000-37 on September 15, 2000, which provides a safe-harbor for how to properly structure a Reverse 1031 Exchange transaction. In a regular deferred exchange, an investor has 45 days to identify potential replacement property. Once the identification deadline passes, the investor is locked into that list of potential properties, and has to close on one or more of those properties within 180 days in order to complete a successful 1031 exchange. In a seller’s market with low inventory, these time frames can be very challenging. By contrast, a reverse exchange, allows an investor can take the time to find the perfect replacement property.
3. Delayed Exchange
In a delayed exchange, the exchanger hands over a particular property (known as the “relinquished” property) before getting a property in exchange (the “replacement” property). The transfer order sees the relinquished property go to the recipient before the replacement property comes into possession of the exchanger.
4. Improvement Exchange
Improvement exchanges offer a unique method of acquiring a property and turning it into what you want. The improvements to an acquired property may be as simple as repairs to a building or as complex as brand-new construction. What’s more, you could get some of your existing property improved in the bargain.
5. Blended Exchange
Blended 1031 exchanges combine one or more standard exchange types such as delayed, improvement, or reverse exchanges to create a customized exchange.
Marty: So, I’ve been doing this since the mid-1980s. I’ve done approximately by my count, 25,000 exchanges for clients during that period. So, I’m very experienced, and can usually figure out answers to most questions that people have. So basically, 1031 itself, this is the language from section 1031. And it basically says no gain is recognized if property is exchanged that’s been held either for use in a trade or business or for investment if it’s exchanged for like kind property. So that’s the 1031 section itself. Pretty straightforward.
But I underlined a few of the words because I want to take a few minutes to expound a little bit about the significance of those words. So, the first one is the word, exchange. An exchange means that the sale and purchase have to be mutually interdependent. That’s kind of a somewhat mumbo jumbo, but what it really means is that you have 180 days from your sale and an exchange to close on a replacement property. But the way the IRS looks at it, there’s more to it than just that you can’t just sell on day one and then sometime later, use the proceeds to buy a new property, there has to be an exchange event with somebody.
You may have heard the term Qualified Intermediary. Some of you know that’s the key to making an exchange happen, because what’s really happening is, the old property is being sold to the Qualified Intermediary, or QI (cue eye) as we say, and the QI is transferring their property to the client’s buyer.
On the back end, within 180 days, the QI is acquiring the new property from the seller and transferring that property back to the buyer. So that’s why the client has an exchange experience because they sold to the QI and the buyer acquired through QI. So, it’s different than just selling and buying. It’s a smoke and mirrors to some extent, but this is the way the IRS allows it to be realized as a deferred tax situation. Now, it also says that the property has to be held for investment or for use in a business or trade. So if someone’s a flipper, or you know, otherwise, they just want to acquire the property and turn around quickly, but don’t have an intent to hold it, it doesn’t really qualify for exchange treatment. And the same thing is true with a replacement property.
The one you’re selling has to be one that you have held for investment. And the one that you acquire, it has to be one that you hold for investment. So quick turnarounds are kind of frowned upon. For exchange purposes, a lot of people will say, well, is there a timeline safe harbor for how long I have to hold it before it’s eligible? The answer is no, a lot of times, you’ll hear people say two years, there’s no such thing. It’s a matter of what the intent is when you enter into the transaction. So, if you start with the intent to fix it up and put it back up for sale, that’s not going to qualify. The mere passage of time isn’t dispositive of the issue.
So again, has to be used in a trade or for business or for investment. People that have let’s say, inventory like vacation homes or second homes doesn’t qualify. Likewise, those aren’t considered to hold for investment, they’re held for personal use. And then I mentioned before that flippers don’t qualify because of this holding period, requirement. And lastly, the properties have to be like kind. As many of you know, when the new tax laws came into effect in January of 2018, where they reduce capital gains rates and so on. From 1921 until that time, in 2018, personal property exchanges could be done. And examples are rail cars and aircraft and off lease assets. And it’s actually was a bigger field in general than the real estate field was.
But in 2018, the IRS took away personal property from being able to have exchange treatment, only leaving real estate. Here’s some examples of some real estate assets that are like kind to one another. So, fee interest is the most typical kind of ownership people have in real estate. If you own your own investment homes, or most other investments are just considered fee interests, but you can have mineral rights like oil production, water rights, I personally do a lot of business with cell tower sales and billboard sales. Long term leases can be disrupted domain exchanges, sales under contract, contract sales, or installment agreements can be done, co Ops, technically are considered you own, you own a share of stock in a corporation that owns the building, and you get a proprietary lease for a unit.
But the IRS has said, it’s so close to conventional real estate that even though it’s not handled that way, we’ll consider for 1031, that it qualifies. You could do property, improvements to property, and the value of those improvements qualify some examples of that people don’t often think about now.
The regulations talk about different safe harbors in how you can deal with the money because one thing was clear, when a seller was doing an exchange, if they receive the proceeds from the sale, even if within the time limits, they use it to make a purchase. It wasn’t qualified because it triggered a taxable sale once they receive the proceeds. So, the proceeds always had to be held back as part of the exchange. And there are different ways which are in the regulations, and to this day, can be used to deal with the holding back to funds. But the bottom line is use of a quality Qualified Intermediary that can facilitate the exchange and hold the funds for all intents and purposes and that’s what my company is, and that’s what I am, a Qualified Intermediary, a QI.
The third safe harbor spelled out how the Qualified Intermediary works. This is language right from the regulations, but it says that the person was acting as a Qualified Intermediary on behalf of the client. They can’t be a disqualified person. So, in theory, you could use your next door neighbor. If you wanted to act as your Qualified Intermediary, they wouldn’t be disqualified. But you couldn’t use your brother or employee because there are agents and they would be qualified disqualified.
Anyway, the main requirement is when you’re doing an exchange with a Qualified Intermediary is that the relinquished property, when it’s being sold by the taxpayer, our client, has to be sold to the QI, and QI, in turn will translate over to the actual buyer. That’s the second bullet point under that section. Likewise, the key is to acquire the replacement property from the seller, and then to conclude the exchange transfer that new property back to the taxpayer.
So, we acquire the relinquished property, and we transfer back the replacement property. Now the drafters of these regulations knew that it would be difficult with transferring with passing deeds and having different parties like the intermediary subject themselves to environmental exposure based on maybe an industrial building is a subject of this. And if they took title to it, now they’re in a chain of title and that creates potential issues for the QI. So, they were very benevolent when they came up with these rules.
They said that you can satisfy this requirement that you acquire the old property from the taxpayer. And you transfer the new property back to the taxpayer by simply having rights in the sale contract of the old property in the rights in the shell purchase contract for the new property assigned to the Qualified Intermediary. So that means that if the client enters into an agreement to sell the property to a buyer, but they assign the rights under that contract to the intermediary, if we want to exercise those rights, we can cause them to issue the deed to us that we would issue the deed to the buyer.
But since they have the contractual ability to take the property the IRS has for tax purposes, it says if the property actually passed through the Qualified Intermediary, I know it’s a little complicated, but that’s what happens. So, every contract exchange transaction, the front end, is assigned to the QI. And the purchase on the back end is assigned to the QI again.