Do You Really Understand §1031 Exchanges? (15 Min. Read)

For any Financial professional, understanding the fundamentals of IRC §1031 and the benefits they offer real estate Investors is an important tool to have in your toolbelt. Being able to identify situations in which a Client may be situated to take advantage of this tax deferral strategy can mean enormous tax savings – real dollars put back in your Clients’ pockets – ultimately enhancing their wealth accumulation ability. Help your Clients achieve this, and you will earn substantial goodwill and loyalty for years to come.

§1031 Exchanges are not a novel concept at this point. Many have a high-level understanding of how they function: sell your investment real estate, reinvest those proceeds into “like-kind” property, and avoid paying tax on the associated capital gain. Yet few know enough to go further than a surface level conversation and actually add value by being able to identify unique circumstances when a §1031 Exchange may or may not be advantageous to the Client – or better yet, help guide them through the process. For this, a deeper understanding of this tax deferral strategy is required.

OVERVIEW

As noted above, a §1031 Exchange is a tax deferral strategy involving the process of reinvesting proceeds from the sale of real property into a replacement property that is of “like-kind”, thereby deferring the tax on the capital gain. The benefits of having the full amount of proceeds available for reinvestment (as opposed to the net after-tax amount) are clear: Investors can redeploy capital into larger or higher quality assets, keeping more of your money at work rather than going to Uncle Sam’s pockets. Additionally, they avoid being bumped up into a higher marginal tax bracket. Some might argue it would be best to pay the tax now and be done with it as opposed to defer to a later date when tax rates are likely to be higher, however, under current tax law an Investor can continue to defer capital gains tax through subsequent §1031 Exchanges and ultimately eliminate this capital gain when the assets are bequeathed to the Investor’s heirs via a step up in tax basis.

The BASICS

This strategy is undoubtedly a major wealth building tool for Investors. But it comes with many rules and regulations that must be strictly adhered to in order to be recognized and accepted by the IRS as a valid exchange. Here are a few of the basic conditions that must be met to qualify for §1031 treatment:

Property Must Be “Like-Kind”

Despite recent changes to IRC §1031 narrowing the types of assets that qualify for “like-kind” exchange treatment, virtually all real property held for business or investment purposes qualifies. There is no restriction between asset classes (commercial, residential, industrial) or types (single family residence or multifamily). Even raw land may be exchanged for other investment real estate. However, it is important to note that primary residences and vacation/second homes are not considered “like-kind” to any property held for business or investment purposes.

All Proceeds Must Be Reinvested To Qualify For Complete Tax Deferral

The replacement property must be of equal value or greater. Any amount of sales proceeds NOT reinvested into replacement property will be subject to capital tax on that portion.

Exchange Must Meet Strict Timelines

45-day window: Replacement Property must be identified within 45 days of selling the relinquished property (typically identified using the “3-Property” Rule).

180-day window: Investor must fully complete the transaction and close on the replacement property within 180 days of selling the relinquished property.

Proceeds MUST be held by a Qualified Intermediary (QI)

It is very important that the Investor does NOT take constructive receipt of the sales proceeds to avoid a busted exchange. In addition to serving the purpose of meeting this requirement, a knowledgeable QI has the processes in place to ensure all of these detailed requirements are checked off the list, as well as help Advisors navigate the many nuances that may differ depending on an Investor’s unique circumstances – a few of which we will discuss next.

The NUANCES

In addition to the aforementioned attributes that are required for qualifying as a valid §1031 Exchange, there are some additional nuances that are not readily known but could greatly impact the outcome of an exchange, and even risk invalidating it if not strictly followed:

Purchase & Sale Agreement must include specific language

Although the IRS does not require language specifying an Investors intent to perform a §1031 Exchange, many still do include it as further support in the event of an IRS audit. What is required, however, is that the contracts allow for assignment – in order to facilitate the QI’s role in the transaction and make sure they avoid the limitations of constructive receipt and adhere to the QI requirements.

Ownership title must be identical

The title to both the relinquished property and replacement properties must be vested in the same name (or said another way, it must be owned by the same “taxpayer”). Therefore, Investors must be cautious if attempting to sell property owned outright personally and purchase the replacement property through an entity (such as a Trust or LLC) or add additional individuals. However, there may be applicable exceptions in certain situations, such as a disregarded entity in which the underlying owner is the same, or adding a souse to the deed of the replacement property and the value of the Exchangers pro-rata percentage ownership is equal to or greater than the net selling price of the relinquished property.

Net equity & VALUE of debt must be equal or greater

Any net equity that is not reinvested is considered taxable “boot” excluded from deferral treatment, and therefore subject to capital gains tax. In addition to the requirement that all net equity be reinvested into the replacement property, Investors will similarly need to replace any previous debt with equal or greater value on the replacement property. Any reduction in this debt value will result in taxable “boot” to the Investor. However, a common misconception is that the Investor must replace debt with debt, when in reality it is simply the VALUE of debt that must be replaced. An Investor has many options for replacing the debt value of the prior loan on the relinquished property – including more traditional financing, seller-financing, private money, or their own cash. Thus, when an Investor sells a leveraged property, they must roll all of the net equity into the replacement property AND replace the value of the leverage using the funding sources mentioned previously.

Tangible personal property may not be eligible for tax deferral

The final regulations on the amended IRC §1031 under the Tax Cuts and Jobs Act (TCJA) limit tax deferral treatment to “real property” as defined by applicable State Laws, thereby effectively excluding any tangible personal property in an exchange from being eligible for tax deferral treatment in a §1031 Exchange, unless it is incidental to the transaction. The final regulations clarify that personal property is incidental if it (i) transferred together with the real property in a standard commercial transaction, and (ii) has an aggregate fair market value of less than 15% of the fair market value of the replacement real property. This may impact an Investor with property types that have significant value allocated to personal property, or that have previously conducted a cost segregation study to break out tangible personal property (otherwise known as §1245 property) to accelerate depreciation on that portion of assets. Any gain on tangible personal property that is NOT incidental to the transaction (i.e. if aggregate FMV of tangible personal property > 15% of the FMV of the replacement real property) will be subject to tax as ordinary income and subject to §1245 depreciation recapture. 

Some BENEFITS

Though Investors certainly benefit indirectly from a §1031 Exchange by being able to upgrade and potentially diversify their real estate portfolio into larger, better quality, or more (multiple) assets, the primary benefit is the ability to defer capital gains taxes and leave more dollars at work generating ROI. The tax exposure avoided through an Exchange is not just the federal capital gains tax. There are many different taxes that may be applicable and that could further reduce an Investor’s net after-tax income from a sale without utilization of a §1031 Exchange deferral:

• Federal Long-Term Capital Gain Tax
• Net Investment Income Tax (NIIT)
• State and Local Taxes
• Transfer Tax
• Depreciation Recapture
• Alternative Minimum Tax (AMT)
• Increase in Marginal Tax Bracket

Keep in mind that an Investor may continue to utilize a §1031 Exchange on future sales, effectively deferring tax indefinitely until they pass – ultimately eliminating the deferred tax entirely when the assets are bequeathed to their heirs via a step up in basis.

More OPPORTUNITIES

The content thus far has been focused on the traditional application of IRC §1031 as it applies to a “like-kind” transaction of direct real property for more direct real property. However, there are many more opportunities that can be used in conjunction with a §1031 Exchange, or that function very similarly, that Financial Professionals and Investors may not be aware of:

• 1033 Exchange
• 1031 Exchange using DSTs (check out the Top 5 Reasons DSTs Can Help Your Clients)
• 1031 Exchange using DSTs paired with §721 UpREIT Transaction
• “Reverse §1031 Exchange” with Qualified Opportunity Zone Funds

Understanding the nuances and complexities with implementing §1031 Exchanges can be challenging to navigate, but the benefits can be enormous to your Clients’ wealth building ability and minimization of tax exposure. The CPA Fiduciary Alliance™ helps remove the complexity behind these advanced tax deferral strategies and assists in the application and implementation process with your Clients. Please reach out to info@cpafateam.com or to myself directly below for more information on our CPA Fiduciary Alliance™ Partnership opportunities and how we can assist if you have Clients interested in a §1031 Exchange.

Maxwell E. Carlson, CPA

Team Lead – CPA Fiduciary Alliance™

Business Development Advisor – Caitlin John PWM

Investment Advisor Representative – Briggs Financial Group

mcarlson@epadvisornetwork.com

Maxwell E. Carlson, CPA

Team Lead – CPA Fiduciary Alliance™

Business Development Advisor – Caitlin John PWM

Investment Advisor Representative – Briggs Financial Group

mcarlson@epadvisornetwork.com

DISCLAIMER: Some of the risks related to investing in commercial real estate include, but are not limited to: market risks such as local property supply and demand conditions; tenants’ inability to pay rent; tenant turnover; inflation and other increases in operating costs; adverse changes in laws and regulations; relative liquidity of real estate investments; changing market demographics; acts of God such as earthquakes, floods or other uninsured losses; interest rate fluctuations; and availability of financing.

This is a brief and general description of certain §1031 guidelines. There are various risks related to purchasing securities as part of a §1031 exchange, including tax complexity, liquidity and restrictions on ownership and transfer. Because each prospective investor’s tax implications are different, all prospective investors should consult with their tax advisors.

Entry Point Advisor Network and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.