1031 Exchanges – What They Are, What They Do, and Effecting a 1031 Exchange in Three Basic Ways

by Ron Holmes 

You may be fortunate enough to own a real estate asset that has substantially appreciated in value over the years. You may think it’s a good market to realize the gain on that asset, but you do not want to pay the federal taxes that will be due if you sell the asset. Or, maybe you own a real estate asset and desire to move into a different real estate asset without having to pay federal taxes on the sale of your current asset.

Your question becomes: How do I dispose of a real estate asset and move into another real estate asset without paying the federal tax on the gain that results from the sale?

1031 Exchanges Defer Federal Taxes

First, let me say one can never escape paying federal taxes on the real estate assets you hold. Even if you hold your real estate assets until you die, your estate may pay federal taxes on the value of that real estate above your cost to purchase and carry it.

If you prefer to defer the payment of federal taxes on the sale of your real estate assets during your lifetime, then you may want to consider engaging in a tax deferred exchange of your real estate for other real estate pursuant to Section 1031 of the Internal Revenue Code of 1986, as amended (for simplicity’s sake, a “1031 Exchange”). Properly structured, a 1031 Exchange will allow you to defer the payment of federal income tax on the gain realized by a sale of your real estate asset if you acquire another like kind real estate asset the value of which exceeds the value of the real estate asset you desire to dispose of.

“Like Kind” Investment Properties

A 1031 Exchange must involve a “like kind” property. Most real estate will be like kind to other real estate, but exceptions do exist (e.g., US real estate versus foreign real estate). Also, certain real estate simply does not qualify as like kind, such as property held for personal use (e.g., primary residence, second home, and possibly vacation home). To qualify as like kind, the property you intend to exchange and the property you intend to acquire via the exchange must each be investment properties (that is, they either generate income, such as a rental property, or they are expected to increase in value, such as vacant land that will appreciate in value).

You can effect a 1031 Exchange in three basic ways.

1. Simultaneous Exchange. If you know you want to dispose of a real estate asset and you know exactly which other real estate asset you want to acquire, you can effect a simultaneous 1031 Exchange of the two real estate assets. Essentially, you exchange your real estate asset with another person for their real estate asset. Subject to various restrictions and limitations, the federal tax you would have paid on the gain from the sale of your real estate will be deferred until you sell the real estate you acquired as a result of the exchange.
2. Deferred Exchange. What if you do not yet know what real estate asset you wish to acquire or you have not yet finalized the terms for such purchase? You can set up a Deferred 1031 Exchange (also known as a “Forward Exchange”). In this scenario, the transaction must be handled by a qualified intermediary (“QI”). First, you “sell” your property. However, a QI holds the proceeds from the relinquished property and then disburses those proceeds to acquire a replacement property. In this scenario, all the QI does is hold the proceeds from the sale of the relinquished property until those proceeds are used to purchase the replacement property. Title does not pass through the QI. Of course, there are limitations. From the date you sell the relinquished property, you have only 45 days to identify the replacement property. The identification must be specific and in writing and delivered to the QI or the Seller of the replacement property. Then, you have only 180 days after the sale of the relinquished property to effect the acquisition.
3. A Reverse 1031 Exchange. In its simplest form, this scenario involves an investor who finds a replacement property before he is ready to dispose of his current property. In other words, you have found a property that you must move fast on to acquire and do not have time to set up a “sale” of your property, but you nevertheless wish to effect a tax-deferred exchange. This type of exchange is far more complicated than a Simultaneous Exchange or a Deferred Exchange and involves an Exchange Accommodation Titleholder (“EAT”) and a QI. The EAT is the titleholder and the QI is the liaison between seller, buyer and the IRS and is the one who is responsible to transfer the titles of the replacement property and relinquished property. The timeline is quick. After the purchase of the replacement property, the investor has 45 days to identify the property to be relinquished and then 135 days to sell same, a total of 180 days.In a Reverse 1031 Exchange, there are two possible scenarios: Exchange Last where you have found a replacement property but are not yet able to effect a “sale” of your property (to wit, the replacement property is purchased and parked with the EAT until the relinquished property is sold); or Exchange First where the relinquished property is parked with the EAT until the replacement property is “purchased”. These scenarios are far more complicated than the scope of this article.

All of this is to say that smart planning can result in the deferral of federal taxes on the gain from the “sale” of real estate if the transaction is structured as a 1031 Exchange. This material has been presented in a very simple way, but you are forewarned that there is never anything simple about deferring federal taxes. If you’re considering a 1031 Exchange, you are encouraged to seek the advice of a CPA or attorney who is experienced in such matters.

When it matters™, you can contact Holmes Firm PC for guidance.   Contact Ron Holmes directly at 469.317.3424 or email him.