Category: 1031 Exchange General

Over the years we have written many posts on a variety of technical aspects of IRC Section 1031 Like-Kind Exchanges. We have written about 1031 Exchange basics; reverse and build-to-suit/improvement exchanges; and about various complex issues in 1031 exchanges. In recent years, new regulations regarding the definition of real estate were evoked, and we covered those in another recent post.
We must remember, that Congress limited the application of Section 1031 to real property, by eliminating personal property, with the passage of the Tax Cuts and Jobs Act of 2017 (TCJA). Effective as of January 1, 2018, only transactions involving interests in real property qualify for 1031 exchange treatment.
Recently, we have encountered some rare situations involving unique investment opportunities. Despite leaving real estate as the only asset class, sometimes it is not immediately clear if a type of asset owned is like-kind to conventional real estate ownership. While the majority of 1031 exchanges involve the exchange of one building for another building, or one tract of farmland for another tract of farmland, the term “like-kind” does not mean that the properties being exchanged must be identical in form. Here are some examples of recent transactions involving some less common real property being exchanged. Note that all of these examples were properly structured as 1031 exchanges.
Less Commonly Known Real Property Examples
Boat Slip
Mary sold a multi-family rental property but did not want to reinvest in a similar property. She was considering various replacement property strategies and ultimately acquired a boat slip. Her plan is to treat the boat slip much like an Airbnb or VRBO for short-term rentals. The boat slip she acquired is in Florida, where such properties are transferred by a deeded interest in the property.
Mobile Home
Nicholas sold a rental condominium, and wanted to get away from the rigors of complying with condo association rules. He identified and acquired a double-wide trailer in a mobile home community. Nicholas will be using this mobile home as a rental property. Mobile homes are typically towed into place on their own axles and are initially registered and licensed as motor vehicles. Nicholas’ mobile home was acquired in Florida, where the law allows the mobile home to be affixed to a foundation and utilities, and for the mobile home to then be treated as real property under state law. This “de-titling” process affords similar treatment for mobile homes and manufactured homes in many other states.
Floating Home
Tom sold a small mixed-use property near the beach. He likes that the property is near the water, but the mixed-use nature of the property often resulted in conflicts between the residential tenants and the commercial tenants. Tom found a floating home for sale in a nearby community and wondered whether that would qualify as real property for 1031 exchange purposes. This floating home is moored in a harbor, and loosely attached to water, sewer, and electric lines provided by the harbor. Fortunately for Tom, California, and a couple of other states, classify these floating homes as real property for tax purposes, and generally treat them like real estate. Upon completion of the purchase, Tom will rent out the home, using it entirely as an investment/business use property.
Easement to Delaware Statutory Trust
Susan owned a commercial property at a busy intersection in her town. Around the corner, there was another small commercial property where the parking lot floods every time there is any substantial rain. To access the nearest storm sewer, that owner needed access across Susan’s property. Susan negotiated for the sale of a perpetual easement for the drain across her property. Susan was advised that the sale of the easement would be fully taxable as capital gains, so she structured the sale as part of a 1031 exchange. Working with her advisors, she reinvested the entire sale price into a Delaware Statutory Trust (“DST”). Read more about DSTs.
Conservation Easement
Joannie owned one of the few family farms left in her part of the county. Encroaching development and increasing costs put pressure on her to sell the property. Because developers placed such high value on the property, there would be a substantial tax bite if she sold the property outright. After consulting with her advisors, Joannie learned about conservation easements. Read more about conservation easements in 1031 exchanges. Upon further investigation, Joannie sold a conservation easement restricting future development of her family farm. The sale was structured as part of a 1031 exchange, and she reinvested the proceeds in a nearby condo that she will use as a rental property.
RV Resort
Nancy and her spouse owned a recreational vehicle resort. Management and maintenance of the resort was a full-time, year-round job. Nancy finally convinced her spouse that they should sell the resort and spend some time traveling around the country. They successfully negotiated the sale of the resort, and on the advice of their tax and legal advisors, structured the sale of the real property portion of the resort as a 1031 exchange. They reinvested the proceeds into several condos near a university, and enlisted the aid of a property management firm to minimize their management responsibilities
Wind & Solar Farms
David owned a rental condo near his home. His tenants advised him that they would not be renewing the lease, and David had to investigate his options. In the process, his real estate agent presented an offer from a buyer, even before the property was listed for sale. David liked the idea of getting out of the residential landlord business, but did not want to pay the taxes that would be due upon the sale. Working with his advisors, David bought fractional interests in several operating solar and wind farms in several states around the country. The sale and purchase were part of a properly structured 1031 exchange, and took David from one property to a portfolio of properties with existing long-term tenants.
These are examples of a few of the unique opportunities our clients have explored recently. There are many other unique opportunities out there for creative investors, such as oil and gas royalties, mineral rights, water rights, and transferrable development rights, which also qualify for 1031 exchange treatment. Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
Some of the strategies discussed here may not work in all states, and some states may impose special rules on some of these transactions. As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before closing on the sale of the relinquished property.

Section 1031 of the Internal Revenue Code allows an owner of business or investment real estate to sell old property (relinquished property) and acquire new property (replacement property) without paying any taxes on the profit of the sale of the old property. The principle underlying these “tax-deferred exchanges” is that by using the exchange value in one property to buy another—instead of receiving cash for that exchange value—a property owner is simply continuing the investment in the original property. As such, the IRS won’t recognize the sale as a taxable event, provided that the owner (referred to in this article as the “taxpayer” or “exchanger”) adheres to the many rules governing exchanges.
The purpose of this article is to provide an overview of some of the most fundamental 1031 exchange rules and concepts, as well as to clarify some common misconceptions. Each concept is discussed below.
Calculating Taxes Due Upon Sale VS 1031 Exchange
As a starting point, a taxpayer should always have a sense of his or her hypothetical tax liability before deciding whether to do an exchange. In very broad terms, the ultimate amount of tax is determined by “capital gain,” which is generally determined by subtracting the amount a taxpayer originally paid for a property from the amount which he or she sells it for. For instance, if Betty originally bought an apartment building in Omaha for $100,000 (her “cost basis”) and sells it for $250,000, her capital gain is $150,000. Betty may also add the value of any “capital improvements” she made during her ownership to her cost basis, which would reduce her recognized capital gain.
Betty’s $150,000 gain—provided it is long-term capital gain—is taxed at 15-20% depending on Betty’s income level. Betty probably also took a “depreciation” deduction over the period she owned the property, say, a total of $20,000. Depreciation is “recaptured” via a 25% tax upon sale. Betty’s gain could also be subject to state capital gain tax and/or depreciation recapture. Lastly, if Betty is a single person earning over $200,000 in the year of sale (or, for married couples filing jointly, earning over $250,000 in the year of sale), Betty would also be subject to the Net Investment Income Tax (“NIIT”) at the rate of 3.8%. The income pertaining to the sale of the property in addition to her other sources of income is included in determining whether Betty was subject to the NIIT. Some may be familiar with the NIIT by one of its nicknames: “Medicare” or “Obamacare Tax”.
In this example, Betty’s (approximate) tax liability would be:
 
$22,500 in federal capital gain tax (15% of $150,000)
$5,000 in depreciation recapture (25% of $20,000)
$7,500 in state capital gain tax (5% of $150,000—actual amount varies by state)
$5,700 in NIIT tax ($5,700)
Total tax liability = $40,700 (Click for the 1031 Exchange calculator)
 
Note: Mortgage debt and the amount of Betty’s net cash proceeds after mortgage debt is paid off is not what determines capital gain. 
Taxes are Deferred, Not Eliminated with a 1031 Exchange
If Betty decides she wants to reinvest the $40,700 she would otherwise pay in taxes into new real estate, she can defer, rather than eliminate, her capital gain, depreciation recapture, and other tax liability. But, if and when she eventually cashes out by selling the property she bought as replacement property, she will owe the $40,700 at that time, plus whatever additional tax liability accrued on the new property.
Exception: Upon the death of an exchanger, his or her heirs receive a “step up” in basis that does effectively eliminate the deferred taxes. 
Role of a Qualified Intermediary
The most common kind of 1031 exchange is a “forward” or “delayed” exchange using a Qualified Intermediary, or QI, like Accruit. Rather than require an actual swap of one property—i.e., transferring relinquished property to Party A and also receiving replacement property from the same Party A—the forward exchange process effectively allows an exchanger to sell relinquished property to a third-party buyer and within 180 days thereafter acquire replacement property from a third-party seller, hence the “delayed” terminology.
The critical parts of this structure are that: (1) the QI is assigned the exchanger’s rights in both the relinquished and replacement property contracts, which allows the taxpayer to “exchange” properties with the QI, as required by Section 1031; and (2) the QI receives the net proceeds from the sale of relinquished property and uses them as directed by the taxpayer to acquire replacement property. If a taxpayer, or a disqualified person like a relative or agent, receives the funds, even briefly, the exchange won’t be valid.
Note: If replacement property must be acquired before relinquished property is sold—an increasingly common scenario in today’s tight real estate market—a “reverse exchange,” may be a possibility.
1031 Exchange Timing Requirements
Section 1031 has strict timing and identification requirements. If Betty elects to do an exchange, she must identify replacement property within 45 days after the date she closes the sale of her apartment building, and she has 180 days from the date of closing to ultimately acquire replacement property (135 days from the identification deadline).
With regard to identification, Betty may identify up to three potential replacement properties, and ultimately close on any one of them. If she wishes to identify more than three properties, she may do so provided that the combined fair market value of all identified properties does not exceed the 200% of the value of the relinquished property. In Betty’s example, the combined value of four or more identified properties could not be more than $500,000. If a taxpayer identifies more than three replacement properties and violates this “200% rule,” he or she must close on 95% of the value of all replacement properties, which in most circumstances means all of them. Read our article on Timing and identification for more details. 
Like-Kind Property in a 1031 Exchange
Relinquished property must be “like-kind” to replacement property. Despite the term “like-kind,” the two properties need not actually be of the same type or quality. In fact, all real estate is “like-kind” to all other real estate under Section 1031, provided that the exchanger has the intent to hold it for business or investment use (see below). Properties can also be exchanged across state lines. So, Betty could exchange her apartment building in Omaha for an office building in Tampa, a beachfront condo in Hawaii, or ranchland in Wyoming. Additionally, one property can be exchanged for multiple properties and vice versa.
Frequently, an exchanger wishes to acquire an interest in a multi-member LLC or other partnership that owns real estate as replacement property. However, interests in an entity are not like-kind and thus do not qualify for exchange treatment, even if it’s a special-purpose entity that only owns real estate. An exchanger may acquire a tenancy-in-common or other fractional interest in real estate, including an interest in a Delaware Statutory Trust, but the replacement property must be real estate, or another interest that qualifies as like-kind, like a leasehold interest longer than 30 years.
Qualified Use and Holding Period
As emphasized above, under Section 1031 a taxpayer must intend to hold both the relinquished and replacement properties for investment or use in a trade or business. Neither vacation homes nor primary residences qualify for 1031 exchange treatment, with some limited caveats. Holding vacant land for the appreciation in value, even if it generates no income, satisfies the rule, where, conversely, allowing a family member to “lease” property for less than fair-market-value rent may be problematic. A developer intending to “flip” property following development would not be eligible for 1031 treatment.
This holding period requirement raises the question of how long a taxpayer must hold property to qualify for 1031 treatment. The answer: it depends. While Section 1031 doesn’t specify a particular duration, time is relevant to determining intent. Two years is generally regarded as sufficient, and a shorter period of time could suffice if a taxpayer can demonstrate actual intent to hold the property at the time it was acquired. Perhaps an exchanger entered into a five-year commercial lease with a replacement property tenant shortly after acquiring the property, but because of quick appreciation in value receives an attractive cash offer after one year of ownership. Under such circumstances, the taxpayer may be excused for the relatively short holding period.
Same Taxpayer Requirement
The taxpayer who owns relinquished property must be the same taxpayer that acquires replacement property. The taxpayer may be an individual or entity and may not necessarily be the party on the deed. For instance, the taxpayer may own property in a living trust, an Illinois-type land trust, or a single-member LLC (“SMLLC”), all of which are generally “disregarded entities” for tax purposes, which means the entities don’t file their own tax returns but rather their assets are reported on the underlying taxpayer’s tax returns. Essentially, although they may provide important protection of personal assets or be effective estate planning strategies, the IRS treats them for tax purposes as if they don’t exist. So, if Betty owned her apartment building in Betty’s Investments, LLC, a SMLLC and thus disregarded entity, she could acquire replacement property in the same LLC, or a different SMLLC, or in her individual name, etc. 
A tax partnership, however, is not a disregarded entity, it files its own tax returns and issues a K-1 to each partner/member and accordingly is a distinct tax entity. For example, if Betty and her sister Blanche owned the Omaha apartment building in a two-member LLC called BB Investments, LLC, the LLC—not Betty and Blanche as individuals—would be the taxpayer for exchange purposes. As such, BB Investments, LLC would have to acquire replacement property. If Betty and Blanche acquired it in their individual names, they would violate the same-taxpayer requirement and invalidate the exchange, unless they used a technique called “drop and swap.” The drop and swap technique involves converting partnership interests to interests in the underlying real estate itself before an exchange.
Avoiding “Boot” By Purchasing Replacement Property of Equal or Greater Value
To fully defer taxes on all gain realized from the sale of relinquished property, an exchanger must acquire replacement property of equal or greater value to the relinquished property. This includes replacing any mortgage debt paid off at closing of the relinquished property with new mortgage debt on replacement property, or new cash. In other words, if Betty sells her apartment building for $250,000, she would have to acquire replacement property of at least $250,000, regardless of the amount of her net proceeds after debt payoff. If she paid off $100,000 in mortgage debt and only realized $150,000 in net proceeds, she would still have to acquire a $250,000 replacement property, and offset the $100,000 mortgage payoff with a new mortgage on her replacement property, or $100,000 of new cash. Cash received or debt paid off that is not offset by new debt or new cash is referred to as “cash boot” or “mortgage boot,” respectively.
Note: An exchanger is permitted to cash out a portion of the value of relinquished property, but would be taxed on that amount, starting with 25% depreciation recapture tax.
Consult With a Knowledgeable QI
As is apparent from the above discussion, successfully completing a 1031 exchange requires compliance with a number of rules. This article is a useful starting point to understand some of the most basic requirements, but is by no means exhaustive. We at Accruit are standing by to discuss your specific scenario and whether an exchange is advisable under your particular circumstances.
 

Section 1031 of the Internal Revenue Code allows an owner of business or investment real estate to sell old property (relinquished property) and acquire new property (replacement property) without paying any taxes on the profit of the sale of the old property. The principle underlying these “tax-deferred exchanges” is that by using the exchange value in one property to buy another—instead of receiving cash for that exchange value—a property owner is simply continuing the investment in the original property. As such, the IRS won’t recognize the sale as a taxable event, provided that the owner (referred to in this article as the “taxpayer” or “exchanger”) adheres to the many rules governing exchanges.
The purpose of this article is to provide an overview of some of the most fundamental 1031 exchange rules and concepts, as well as to clarify some common misconceptions. Each concept is discussed below.
Calculating Taxes Due Upon Sale VS 1031 Exchange
As a starting point, a taxpayer should always have a sense of his or her hypothetical tax liability before deciding whether to do an exchange. In very broad terms, the ultimate amount of tax is determined by “capital gain,” which is generally determined by subtracting the amount a taxpayer originally paid for a property from the amount which he or she sells it for. For instance, if Betty originally bought an apartment building in Omaha for $100,000 (her “cost basis”) and sells it for $250,000, her capital gain is $150,000. Betty may also add the value of any “capital improvements” she made during her ownership to her cost basis, which would reduce her recognized capital gain.
Betty’s $150,000 gain—provided it is long-term capital gain—is taxed at 15-20% depending on Betty’s income level. Betty probably also took a “depreciation” deduction over the period she owned the property, say, a total of $20,000. Depreciation is “recaptured” via a 25% tax upon sale. Betty’s gain could also be subject to state capital gain tax and/or depreciation recapture. Lastly, if Betty is a single person earning over $200,000 in the year of sale (or, for married couples filing jointly, earning over $250,000 in the year of sale), Betty would also be subject to the Net Investment Income Tax (“NIIT”) at the rate of 3.8%. The income pertaining to the sale of the property in addition to her other sources of income is included in determining whether Betty was subject to the NIIT. Some may be familiar with the NIIT by one of its nicknames: “Medicare” or “Obamacare Tax”.
In this example, Betty’s (approximate) tax liability would be:
 
$22,500 in federal capital gain tax (15% of $150,000)
$5,000 in depreciation recapture (25% of $20,000)
$7,500 in state capital gain tax (5% of $150,000—actual amount varies by state)
$5,700 in NIIT tax ($5,700)
Total tax liability = $40,700 (Click for the 1031 Exchange calculator)
 
Note: Mortgage debt and the amount of Betty’s net cash proceeds after mortgage debt is paid off is not what determines capital gain. 
Taxes are Deferred, Not Eliminated with a 1031 Exchange
If Betty decides she wants to reinvest the $40,700 she would otherwise pay in taxes into new real estate, she can defer, rather than eliminate, her capital gain, depreciation recapture, and other tax liability. But, if and when she eventually cashes out by selling the property she bought as replacement property, she will owe the $40,700 at that time, plus whatever additional tax liability accrued on the new property.
Exception: Upon the death of an exchanger, his or her heirs receive a “step up” in basis that does effectively eliminate the deferred taxes. 
Role of a Qualified Intermediary
The most common kind of 1031 exchange is a “forward” or “delayed” exchange using a Qualified Intermediary, or QI, like Accruit. Rather than require an actual swap of one property—i.e., transferring relinquished property to Party A and also receiving replacement property from the same Party A—the forward exchange process effectively allows an exchanger to sell relinquished property to a third-party buyer and within 180 days thereafter acquire replacement property from a third-party seller, hence the “delayed” terminology.
The critical parts of this structure are that: (1) the QI is assigned the exchanger’s rights in both the relinquished and replacement property contracts, which allows the taxpayer to “exchange” properties with the QI, as required by Section 1031; and (2) the QI receives the net proceeds from the sale of relinquished property and uses them as directed by the taxpayer to acquire replacement property. If a taxpayer, or a disqualified person like a relative or agent, receives the funds, even briefly, the exchange won’t be valid.
Note: If replacement property must be acquired before relinquished property is sold—an increasingly common scenario in today’s tight real estate market—a “reverse exchange,” may be a possibility.
1031 Exchange Timing Requirements
Section 1031 has strict timing and identification requirements. If Betty elects to do an exchange, she must identify replacement property within 45 days after the date she closes the sale of her apartment building, and she has 180 days from the date of closing to ultimately acquire replacement property (135 days from the identification deadline).
With regard to identification, Betty may identify up to three potential replacement properties, and ultimately close on any one of them. If she wishes to identify more than three properties, she may do so provided that the combined fair market value of all identified properties does not exceed the 200% of the value of the relinquished property. In Betty’s example, the combined value of four or more identified properties could not be more than $500,000. If a taxpayer identifies more than three replacement properties and violates this “200% rule,” he or she must close on 95% of the value of all replacement properties, which in most circumstances means all of them. Read our article on Timing and identification for more details. 
Like-Kind Property in a 1031 Exchange
Relinquished property must be “like-kind” to replacement property. Despite the term “like-kind,” the two properties need not actually be of the same type or quality. In fact, all real estate is “like-kind” to all other real estate under Section 1031, provided that the exchanger has the intent to hold it for business or investment use (see below). Properties can also be exchanged across state lines. So, Betty could exchange her apartment building in Omaha for an office building in Tampa, a beachfront condo in Hawaii, or ranchland in Wyoming. Additionally, one property can be exchanged for multiple properties and vice versa.
Frequently, an exchanger wishes to acquire an interest in a multi-member LLC or other partnership that owns real estate as replacement property. However, interests in an entity are not like-kind and thus do not qualify for exchange treatment, even if it’s a special-purpose entity that only owns real estate. An exchanger may acquire a tenancy-in-common or other fractional interest in real estate, including an interest in a Delaware Statutory Trust, but the replacement property must be real estate, or another interest that qualifies as like-kind, like a leasehold interest longer than 30 years.
Qualified Use and Holding Period
As emphasized above, under Section 1031 a taxpayer must intend to hold both the relinquished and replacement properties for investment or use in a trade or business. Neither vacation homes nor primary residences qualify for 1031 exchange treatment, with some limited caveats. Holding vacant land for the appreciation in value, even if it generates no income, satisfies the rule, where, conversely, allowing a family member to “lease” property for less than fair-market-value rent may be problematic. A developer intending to “flip” property following development would not be eligible for 1031 treatment.
This holding period requirement raises the question of how long a taxpayer must hold property to qualify for 1031 treatment. The answer: it depends. While Section 1031 doesn’t specify a particular duration, time is relevant to determining intent. Two years is generally regarded as sufficient, and a shorter period of time could suffice if a taxpayer can demonstrate actual intent to hold the property at the time it was acquired. Perhaps an exchanger entered into a five-year commercial lease with a replacement property tenant shortly after acquiring the property, but because of quick appreciation in value receives an attractive cash offer after one year of ownership. Under such circumstances, the taxpayer may be excused for the relatively short holding period.
Same Taxpayer Requirement
The taxpayer who owns relinquished property must be the same taxpayer that acquires replacement property. The taxpayer may be an individual or entity and may not necessarily be the party on the deed. For instance, the taxpayer may own property in a living trust, an Illinois-type land trust, or a single-member LLC (“SMLLC”), all of which are generally “disregarded entities” for tax purposes, which means the entities don’t file their own tax returns but rather their assets are reported on the underlying taxpayer’s tax returns. Essentially, although they may provide important protection of personal assets or be effective estate planning strategies, the IRS treats them for tax purposes as if they don’t exist. So, if Betty owned her apartment building in Betty’s Investments, LLC, a SMLLC and thus disregarded entity, she could acquire replacement property in the same LLC, or a different SMLLC, or in her individual name, etc. 
A tax partnership, however, is not a disregarded entity, it files its own tax returns and issues a K-1 to each partner/member and accordingly is a distinct tax entity. For example, if Betty and her sister Blanche owned the Omaha apartment building in a two-member LLC called BB Investments, LLC, the LLC—not Betty and Blanche as individuals—would be the taxpayer for exchange purposes. As such, BB Investments, LLC would have to acquire replacement property. If Betty and Blanche acquired it in their individual names, they would violate the same-taxpayer requirement and invalidate the exchange, unless they used a technique called “drop and swap.” The drop and swap technique involves converting partnership interests to interests in the underlying real estate itself before an exchange.
Avoiding “Boot” By Purchasing Replacement Property of Equal or Greater Value
To fully defer taxes on all gain realized from the sale of relinquished property, an exchanger must acquire replacement property of equal or greater value to the relinquished property. This includes replacing any mortgage debt paid off at closing of the relinquished property with new mortgage debt on replacement property, or new cash. In other words, if Betty sells her apartment building for $250,000, she would have to acquire replacement property of at least $250,000, regardless of the amount of her net proceeds after debt payoff. If she paid off $100,000 in mortgage debt and only realized $150,000 in net proceeds, she would still have to acquire a $250,000 replacement property, and offset the $100,000 mortgage payoff with a new mortgage on her replacement property, or $100,000 of new cash. Cash received or debt paid off that is not offset by new debt or new cash is referred to as “cash boot” or “mortgage boot,” respectively.
Note: An exchanger is permitted to cash out a portion of the value of relinquished property, but would be taxed on that amount, starting with 25% depreciation recapture tax.
Consult With a Knowledgeable QI
As is apparent from the above discussion, successfully completing a 1031 exchange requires compliance with a number of rules. This article is a useful starting point to understand some of the most basic requirements, but is by no means exhaustive. We at Accruit are standing by to discuss your specific scenario and whether an exchange is advisable under your particular circumstances.
 

Section 1031 of the Internal Revenue Code allows an owner of business or investment real estate to sell old property (relinquished property) and acquire new property (replacement property) without paying any taxes on the profit of the sale of the old property. The principle underlying these “tax-deferred exchanges” is that by using the exchange value in one property to buy another—instead of receiving cash for that exchange value—a property owner is simply continuing the investment in the original property. As such, the IRS won’t recognize the sale as a taxable event, provided that the owner (referred to in this article as the “taxpayer” or “exchanger”) adheres to the many rules governing exchanges.
The purpose of this article is to provide an overview of some of the most fundamental 1031 exchange rules and concepts, as well as to clarify some common misconceptions. Each concept is discussed below.
Calculating Taxes Due Upon Sale VS 1031 Exchange
As a starting point, a taxpayer should always have a sense of his or her hypothetical tax liability before deciding whether to do an exchange. In very broad terms, the ultimate amount of tax is determined by “capital gain,” which is generally determined by subtracting the amount a taxpayer originally paid for a property from the amount which he or she sells it for. For instance, if Betty originally bought an apartment building in Omaha for $100,000 (her “cost basis”) and sells it for $250,000, her capital gain is $150,000. Betty may also add the value of any “capital improvements” she made during her ownership to her cost basis, which would reduce her recognized capital gain.
Betty’s $150,000 gain—provided it is long-term capital gain—is taxed at 15-20% depending on Betty’s income level. Betty probably also took a “depreciation” deduction over the period she owned the property, say, a total of $20,000. Depreciation is “recaptured” via a 25% tax upon sale. Betty’s gain could also be subject to state capital gain tax and/or depreciation recapture. Lastly, if Betty is a single person earning over $200,000 in the year of sale (or, for married couples filing jointly, earning over $250,000 in the year of sale), Betty would also be subject to the Net Investment Income Tax (“NIIT”) at the rate of 3.8%. The income pertaining to the sale of the property in addition to her other sources of income is included in determining whether Betty was subject to the NIIT. Some may be familiar with the NIIT by one of its nicknames: “Medicare” or “Obamacare Tax”.
In this example, Betty’s (approximate) tax liability would be:
 
$22,500 in federal capital gain tax (15% of $150,000)
$5,000 in depreciation recapture (25% of $20,000)
$7,500 in state capital gain tax (5% of $150,000—actual amount varies by state)
$5,700 in NIIT tax ($5,700)
Total tax liability = $40,700 (Click for the 1031 Exchange calculator)
 
Note: Mortgage debt and the amount of Betty’s net cash proceeds after mortgage debt is paid off is not what determines capital gain. 
Taxes are Deferred, Not Eliminated with a 1031 Exchange
If Betty decides she wants to reinvest the $40,700 she would otherwise pay in taxes into new real estate, she can defer, rather than eliminate, her capital gain, depreciation recapture, and other tax liability. But, if and when she eventually cashes out by selling the property she bought as replacement property, she will owe the $40,700 at that time, plus whatever additional tax liability accrued on the new property.
Exception: Upon the death of an exchanger, his or her heirs receive a “step up” in basis that does effectively eliminate the deferred taxes. 
Role of a Qualified Intermediary
The most common kind of 1031 exchange is a “forward” or “delayed” exchange using a Qualified Intermediary, or QI, like Accruit. Rather than require an actual swap of one property—i.e., transferring relinquished property to Party A and also receiving replacement property from the same Party A—the forward exchange process effectively allows an exchanger to sell relinquished property to a third-party buyer and within 180 days thereafter acquire replacement property from a third-party seller, hence the “delayed” terminology.
The critical parts of this structure are that: (1) the QI is assigned the exchanger’s rights in both the relinquished and replacement property contracts, which allows the taxpayer to “exchange” properties with the QI, as required by Section 1031; and (2) the QI receives the net proceeds from the sale of relinquished property and uses them as directed by the taxpayer to acquire replacement property. If a taxpayer, or a disqualified person like a relative or agent, receives the funds, even briefly, the exchange won’t be valid.
Note: If replacement property must be acquired before relinquished property is sold—an increasingly common scenario in today’s tight real estate market—a “reverse exchange,” may be a possibility.
1031 Exchange Timing Requirements
Section 1031 has strict timing and identification requirements. If Betty elects to do an exchange, she must identify replacement property within 45 days after the date she closes the sale of her apartment building, and she has 180 days from the date of closing to ultimately acquire replacement property (135 days from the identification deadline).
With regard to identification, Betty may identify up to three potential replacement properties, and ultimately close on any one of them. If she wishes to identify more than three properties, she may do so provided that the combined fair market value of all identified properties does not exceed the 200% of the value of the relinquished property. In Betty’s example, the combined value of four or more identified properties could not be more than $500,000. If a taxpayer identifies more than three replacement properties and violates this “200% rule,” he or she must close on 95% of the value of all replacement properties, which in most circumstances means all of them. Read our article on Timing and identification for more details. 
Like-Kind Property in a 1031 Exchange
Relinquished property must be “like-kind” to replacement property. Despite the term “like-kind,” the two properties need not actually be of the same type or quality. In fact, all real estate is “like-kind” to all other real estate under Section 1031, provided that the exchanger has the intent to hold it for business or investment use (see below). Properties can also be exchanged across state lines. So, Betty could exchange her apartment building in Omaha for an office building in Tampa, a beachfront condo in Hawaii, or ranchland in Wyoming. Additionally, one property can be exchanged for multiple properties and vice versa.
Frequently, an exchanger wishes to acquire an interest in a multi-member LLC or other partnership that owns real estate as replacement property. However, interests in an entity are not like-kind and thus do not qualify for exchange treatment, even if it’s a special-purpose entity that only owns real estate. An exchanger may acquire a tenancy-in-common or other fractional interest in real estate, including an interest in a Delaware Statutory Trust, but the replacement property must be real estate, or another interest that qualifies as like-kind, like a leasehold interest longer than 30 years.
Qualified Use and Holding Period
As emphasized above, under Section 1031 a taxpayer must intend to hold both the relinquished and replacement properties for investment or use in a trade or business. Neither vacation homes nor primary residences qualify for 1031 exchange treatment, with some limited caveats. Holding vacant land for the appreciation in value, even if it generates no income, satisfies the rule, where, conversely, allowing a family member to “lease” property for less than fair-market-value rent may be problematic. A developer intending to “flip” property following development would not be eligible for 1031 treatment.
This holding period requirement raises the question of how long a taxpayer must hold property to qualify for 1031 treatment. The answer: it depends. While Section 1031 doesn’t specify a particular duration, time is relevant to determining intent. Two years is generally regarded as sufficient, and a shorter period of time could suffice if a taxpayer can demonstrate actual intent to hold the property at the time it was acquired. Perhaps an exchanger entered into a five-year commercial lease with a replacement property tenant shortly after acquiring the property, but because of quick appreciation in value receives an attractive cash offer after one year of ownership. Under such circumstances, the taxpayer may be excused for the relatively short holding period.
Same Taxpayer Requirement
The taxpayer who owns relinquished property must be the same taxpayer that acquires replacement property. The taxpayer may be an individual or entity and may not necessarily be the party on the deed. For instance, the taxpayer may own property in a living trust, an Illinois-type land trust, or a single-member LLC (“SMLLC”), all of which are generally “disregarded entities” for tax purposes, which means the entities don’t file their own tax returns but rather their assets are reported on the underlying taxpayer’s tax returns. Essentially, although they may provide important protection of personal assets or be effective estate planning strategies, the IRS treats them for tax purposes as if they don’t exist. So, if Betty owned her apartment building in Betty’s Investments, LLC, a SMLLC and thus disregarded entity, she could acquire replacement property in the same LLC, or a different SMLLC, or in her individual name, etc. 
A tax partnership, however, is not a disregarded entity, it files its own tax returns and issues a K-1 to each partner/member and accordingly is a distinct tax entity. For example, if Betty and her sister Blanche owned the Omaha apartment building in a two-member LLC called BB Investments, LLC, the LLC—not Betty and Blanche as individuals—would be the taxpayer for exchange purposes. As such, BB Investments, LLC would have to acquire replacement property. If Betty and Blanche acquired it in their individual names, they would violate the same-taxpayer requirement and invalidate the exchange, unless they used a technique called “drop and swap.” The drop and swap technique involves converting partnership interests to interests in the underlying real estate itself before an exchange.
Avoiding “Boot” By Purchasing Replacement Property of Equal or Greater Value
To fully defer taxes on all gain realized from the sale of relinquished property, an exchanger must acquire replacement property of equal or greater value to the relinquished property. This includes replacing any mortgage debt paid off at closing of the relinquished property with new mortgage debt on replacement property, or new cash. In other words, if Betty sells her apartment building for $250,000, she would have to acquire replacement property of at least $250,000, regardless of the amount of her net proceeds after debt payoff. If she paid off $100,000 in mortgage debt and only realized $150,000 in net proceeds, she would still have to acquire a $250,000 replacement property, and offset the $100,000 mortgage payoff with a new mortgage on her replacement property, or $100,000 of new cash. Cash received or debt paid off that is not offset by new debt or new cash is referred to as “cash boot” or “mortgage boot,” respectively.
Note: An exchanger is permitted to cash out a portion of the value of relinquished property, but would be taxed on that amount, starting with 25% depreciation recapture tax.
Consult With a Knowledgeable QI
As is apparent from the above discussion, successfully completing a 1031 exchange requires compliance with a number of rules. This article is a useful starting point to understand some of the most basic requirements, but is by no means exhaustive. We at Accruit are standing by to discuss your specific scenario and whether an exchange is advisable under your particular circumstances.
 

Christina’s First Investment
After college, Christina chose to continue living with her parents, while she began saving for her future. In time, she had saved $20,000. With the aid of bank financing, Christina invested in her first rental property. She bought a modest 2-bedroom, 1½ bath condo near the local community college for $100,000. Over the time Christina owned the property, she had taken $25,000 in depreciation, paid $25,000 toward her initial mortgage, and her investment grew to $115,000. She decided that it was time to upgrade her investment.
After consulting with her tax and legal advisors, Christina learned that if she sold the condo outright, without the use of Section 1031, she would have to pay depreciation recapture taxes on the $25,000, as well as capital gains taxes on the $15,000.
$25,000 Depreciation
X 25% Federal Depreciation Recapture         $6,250
X 5% State Depreciation Recapture               $1,250
+
$15,000 Capital Gains
X 15% Federal Capital Gains Tax                   $2,250
X 5% State Capital Gains Tax                            $750
TOTAL TAX BITE                                          $10,500
 
Christina’s tax advisor showed her that she would lose approximately 2/3 of her investment gains to taxes if she were to sell the property outright. She had a good outcome with this initial investment and her tax advisor suggested that she structure the sale as part of a Section 1031 exchange, rather than an outright sale. Christina and her tax advisor crunched the numbers again, and learned:
Christina’s original investment                       $20,000
Equity from mortgage payments made          $25,000
Equity from capital gains                                $15,000
TOTAL EQUITY AVAILABLE                        $60,000
 
Christina agreed that a 1031 exchange was the best strategy for her, and she listed her modest condo for sale. Because it was well-maintained and near the community college, there were multiple offers. Christina promptly sought referrals from her tax and legal advisors, who both recommended the same Qualified Intermediary (QI). The QI worked closely with Christina’s advisors and the closing agent to prepare for the sale of her property. Christina was able to net $60,000 after all closing costs, and the closing agent sent this entire amount directly to Christina’s QI.
It is important to note that Christina must use all of her equity in the property – including her original $20,000 investment, the $25,000 paid off of the mortgage balance, and the $15,00 in capital gain – toward the purchase of her replacement property to defer all taxes. This is because if Christina had sought to withdraw her initial investment, the IRS would have characterized those funds as profit rather than the return of her original investment. This would have created a taxable event, which Christina was seeking to avoid.
Christina spent the next several weeks working with her real estate advisor, knowing that she had 45 days to provide her QI with a short list of potential replacement properties. Read this article for more information about the identification rules.
Working with her real estate advisor, Christina found a newer 3-bedroom, 2½ bath townhouse, with a garage, on a quiet street in a desirable neighborhood. Using the $60,000 from the sale of her first condo, Christina financed the remaining $240,000 needed to complete the acquisition of the $300,000 townhouse. Christina’s QI again collaborated with her advisors and the closing agent, and Christina was able to complete the acquisition of her second investment within the exchange period. Read for more information about exchange deadlines.
Consolidating Kelly’s Portfolio
Like Christina, Kelly began investing in real estate right out of college. Over the years, Kelly has built a portfolio of six condos, townhouses, and single-family rentals in four towns near her home. But managing all of these properties was proving to be difficult and time consuming. Kelly wondered whether there was an easier way.
Kelly consulted with her tax and legal advisors, both of whom encouraged her to consider a Section 1031 exchange. Kelly’s portfolio is worth about $800,000, and if she were to sell outright, she would face about $275,000 in state and federal capital gains and depreciation recapture taxes. Kelly agreed that a 1031 exchange was the right way to go, and listed her properties with her local real estate agent. The listing indicated that they could be bought as a bundle, or individually.
Kelly also consulted with the QI that her advisors recommended. During the consultation, the QI pointed out that if she sold the various properties individually over a period of time, but still wanted to use the proceeds of all of them for one purchase, her identification and exchange periods would commence with the sale of the first property. The QI also pointed out that, depending on the timing of the sales, and the possibility that Kelly might want to acquire multiple replacement properties, Kelly could consider establishing multiple exchange accounts.
Fortunately, Kelly’s properties were all desirable, and her broker was able to secure one buyer for the entire portfolio. Kelly and her broker provided the sale contract to the QI, who prepared the necessary exchange documents. The QI worked closely with Kelly’s advisors and the closing agent to ensure that the net sale proceeds were sent directly to the QI rather than to Kelly or her attorney. At closing, the net proceeds of $700,000 (after expenses and paying off mortgage debt of just under $100,000) were sent to the QI, properly starting Kelly’s 1031 exchange.
Working with her real estate advisor, Kelly found a mixed-use, multi-tenant building near her home, consisting of two apartments, two stores, and three townhouses. Using the $700,000 in exchange proceeds, Kelly financed the remaining $900,000 needed to complete the acquisition of this property. (It is important to note that if Kelly wants the full benefits of a 1031 exchange, she would need to replace the debt paid off at the sale of her original property. Kelly obtained a new loan, but she also could have replaced the original debt with fresh cash. Further, Kelly is leveraging her equity to acquire a new property worth significantly more than the one she sold.) Kelly’s QI again worked closely with her advisors and the closing agent, and Kelly was able to complete the acquisition of her consolidated investment within the exchange period.
Grandpa’s Estate Planning and Diversification
Grandpa Al has owned a small shopping center for many years. He had no immediate need to sell the shopping center until he spoke with his new estate planning attorney. During the consultation with the estate planning attorney, Grandpa Al revealed that his Will provides that his four grandchildren will inherit the shopping center. The estate planning attorney pointed out that having four family members inherit one property was a recipe for a new family feud. He pointed out that the four grandchildren would likely have different ideas about what to do with the shopping center, and that he should consider restructuring his real estate investment. The estate planning attorney invited his tax attorney partner into the consultation, who educated Grandpa Al about 1031 exchanges.
Grandpa Al decided that he would sell the shopping center as part of a 1031 exchange. Working with his real estate advisor, Grandpa Al listed the shopping center for sale, and began looking for potential replacement properties.
Because the shopping center was well-maintained, and fully occupied, there were multiple offers. Grandpa Al promptly sought referrals from his tax and legal advisors for a QI. The QI worked closely with Grandpa Al’s advisors and the closing agent to prepare for the sale of the shopping center. Grandpa Al was able to net $1,000,000 after all closing costs, and the closing agent sent this entire amount directly to Grandpa Al’s QI.
Working with his real estate advisor, Grandpa Al found four identical condo units, within walking distance of the local university. Using the $1,000,000 in exchange proceeds, and some additional cash, Grandpa Al, completed the acquisition of the four condos for $1,100,000. Grandpa Al’s QI again worked closely with his advisors and the closing agent, and Grandpa Al was able to complete the acquisition of his newly diversified investment within the exchange period.
Grandpa Al then went back to his estate planning attorney to update his Will, so that each grandchild will inherit their own individual condo unit, and have the added benefit of a step-up in basis upon Grandpa Al’s death. This means that when Grandpa Al dies, his heirs will inherit the property at the fair market value as of the date of his death. Thus, there will be no depreciation recapture or capital gains to recognize.
Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property.

Christina’s First Investment
After college, Christina chose to continue living with her parents, while she began saving for her future. In time, she had saved $20,000. With the aid of bank financing, Christina invested in her first rental property. She bought a modest 2-bedroom, 1½ bath condo near the local community college for $100,000. Over the time Christina owned the property, she had taken $25,000 in depreciation, paid $25,000 toward her initial mortgage, and her investment grew to $115,000. She decided that it was time to upgrade her investment.
After consulting with her tax and legal advisors, Christina learned that if she sold the condo outright, without the use of Section 1031, she would have to pay depreciation recapture taxes on the $25,000, as well as capital gains taxes on the $15,000.
$25,000 Depreciation
X 25% Federal Depreciation Recapture         $6,250
X 5% State Depreciation Recapture               $1,250
+
$15,000 Capital Gains
X 15% Federal Capital Gains Tax                   $2,250
X 5% State Capital Gains Tax                            $750
TOTAL TAX BITE                                          $10,500
 
Christina’s tax advisor showed her that she would lose approximately 2/3 of her investment gains to taxes if she were to sell the property outright. She had a good outcome with this initial investment and her tax advisor suggested that she structure the sale as part of a Section 1031 exchange, rather than an outright sale. Christina and her tax advisor crunched the numbers again, and learned:
Christina’s original investment                       $20,000
Equity from mortgage payments made          $25,000
Equity from capital gains                                $15,000
TOTAL EQUITY AVAILABLE                        $60,000
 
Christina agreed that a 1031 exchange was the best strategy for her, and she listed her modest condo for sale. Because it was well-maintained and near the community college, there were multiple offers. Christina promptly sought referrals from her tax and legal advisors, who both recommended the same Qualified Intermediary (QI). The QI worked closely with Christina’s advisors and the closing agent to prepare for the sale of her property. Christina was able to net $60,000 after all closing costs, and the closing agent sent this entire amount directly to Christina’s QI.
It is important to note that Christina must use all of her equity in the property – including her original $20,000 investment, the $25,000 paid off of the mortgage balance, and the $15,00 in capital gain – toward the purchase of her replacement property to defer all taxes. This is because if Christina had sought to withdraw her initial investment, the IRS would have characterized those funds as profit rather than the return of her original investment. This would have created a taxable event, which Christina was seeking to avoid.
Christina spent the next several weeks working with her real estate advisor, knowing that she had 45 days to provide her QI with a short list of potential replacement properties. Read this article for more information about the identification rules.
Working with her real estate advisor, Christina found a newer 3-bedroom, 2½ bath townhouse, with a garage, on a quiet street in a desirable neighborhood. Using the $60,000 from the sale of her first condo, Christina financed the remaining $240,000 needed to complete the acquisition of the $300,000 townhouse. Christina’s QI again collaborated with her advisors and the closing agent, and Christina was able to complete the acquisition of her second investment within the exchange period. Read for more information about exchange deadlines.
Consolidating Kelly’s Portfolio
Like Christina, Kelly began investing in real estate right out of college. Over the years, Kelly has built a portfolio of six condos, townhouses, and single-family rentals in four towns near her home. But managing all of these properties was proving to be difficult and time consuming. Kelly wondered whether there was an easier way.
Kelly consulted with her tax and legal advisors, both of whom encouraged her to consider a Section 1031 exchange. Kelly’s portfolio is worth about $800,000, and if she were to sell outright, she would face about $275,000 in state and federal capital gains and depreciation recapture taxes. Kelly agreed that a 1031 exchange was the right way to go, and listed her properties with her local real estate agent. The listing indicated that they could be bought as a bundle, or individually.
Kelly also consulted with the QI that her advisors recommended. During the consultation, the QI pointed out that if she sold the various properties individually over a period of time, but still wanted to use the proceeds of all of them for one purchase, her identification and exchange periods would commence with the sale of the first property. The QI also pointed out that, depending on the timing of the sales, and the possibility that Kelly might want to acquire multiple replacement properties, Kelly could consider establishing multiple exchange accounts.
Fortunately, Kelly’s properties were all desirable, and her broker was able to secure one buyer for the entire portfolio. Kelly and her broker provided the sale contract to the QI, who prepared the necessary exchange documents. The QI worked closely with Kelly’s advisors and the closing agent to ensure that the net sale proceeds were sent directly to the QI rather than to Kelly or her attorney. At closing, the net proceeds of $700,000 (after expenses and paying off mortgage debt of just under $100,000) were sent to the QI, properly starting Kelly’s 1031 exchange.
Working with her real estate advisor, Kelly found a mixed-use, multi-tenant building near her home, consisting of two apartments, two stores, and three townhouses. Using the $700,000 in exchange proceeds, Kelly financed the remaining $900,000 needed to complete the acquisition of this property. (It is important to note that if Kelly wants the full benefits of a 1031 exchange, she would need to replace the debt paid off at the sale of her original property. Kelly obtained a new loan, but she also could have replaced the original debt with fresh cash. Further, Kelly is leveraging her equity to acquire a new property worth significantly more than the one she sold.) Kelly’s QI again worked closely with her advisors and the closing agent, and Kelly was able to complete the acquisition of her consolidated investment within the exchange period.
Grandpa’s Estate Planning and Diversification
Grandpa Al has owned a small shopping center for many years. He had no immediate need to sell the shopping center until he spoke with his new estate planning attorney. During the consultation with the estate planning attorney, Grandpa Al revealed that his Will provides that his four grandchildren will inherit the shopping center. The estate planning attorney pointed out that having four family members inherit one property was a recipe for a new family feud. He pointed out that the four grandchildren would likely have different ideas about what to do with the shopping center, and that he should consider restructuring his real estate investment. The estate planning attorney invited his tax attorney partner into the consultation, who educated Grandpa Al about 1031 exchanges.
Grandpa Al decided that he would sell the shopping center as part of a 1031 exchange. Working with his real estate advisor, Grandpa Al listed the shopping center for sale, and began looking for potential replacement properties.
Because the shopping center was well-maintained, and fully occupied, there were multiple offers. Grandpa Al promptly sought referrals from his tax and legal advisors for a QI. The QI worked closely with Grandpa Al’s advisors and the closing agent to prepare for the sale of the shopping center. Grandpa Al was able to net $1,000,000 after all closing costs, and the closing agent sent this entire amount directly to Grandpa Al’s QI.
Working with his real estate advisor, Grandpa Al found four identical condo units, within walking distance of the local university. Using the $1,000,000 in exchange proceeds, and some additional cash, Grandpa Al, completed the acquisition of the four condos for $1,100,000. Grandpa Al’s QI again worked closely with his advisors and the closing agent, and Grandpa Al was able to complete the acquisition of his newly diversified investment within the exchange period.
Grandpa Al then went back to his estate planning attorney to update his Will, so that each grandchild will inherit their own individual condo unit, and have the added benefit of a step-up in basis upon Grandpa Al’s death. This means that when Grandpa Al dies, his heirs will inherit the property at the fair market value as of the date of his death. Thus, there will be no depreciation recapture or capital gains to recognize.
Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property.

Christina’s First Investment
After college, Christina chose to continue living with her parents, while she began saving for her future. In time, she had saved $20,000. With the aid of bank financing, Christina invested in her first rental property. She bought a modest 2-bedroom, 1½ bath condo near the local community college for $100,000. Over the time Christina owned the property, she had taken $25,000 in depreciation, paid $25,000 toward her initial mortgage, and her investment grew to $115,000. She decided that it was time to upgrade her investment.
After consulting with her tax and legal advisors, Christina learned that if she sold the condo outright, without the use of Section 1031, she would have to pay depreciation recapture taxes on the $25,000, as well as capital gains taxes on the $15,000.
$25,000 Depreciation
X 25% Federal Depreciation Recapture         $6,250
X 5% State Depreciation Recapture               $1,250
+
$15,000 Capital Gains
X 15% Federal Capital Gains Tax                   $2,250
X 5% State Capital Gains Tax                            $750
TOTAL TAX BITE                                          $10,500
 
Christina’s tax advisor showed her that she would lose approximately 2/3 of her investment gains to taxes if she were to sell the property outright. She had a good outcome with this initial investment and her tax advisor suggested that she structure the sale as part of a Section 1031 exchange, rather than an outright sale. Christina and her tax advisor crunched the numbers again, and learned:
Christina’s original investment                       $20,000
Equity from mortgage payments made          $25,000
Equity from capital gains                                $15,000
TOTAL EQUITY AVAILABLE                        $60,000
 
Christina agreed that a 1031 exchange was the best strategy for her, and she listed her modest condo for sale. Because it was well-maintained and near the community college, there were multiple offers. Christina promptly sought referrals from her tax and legal advisors, who both recommended the same Qualified Intermediary (QI). The QI worked closely with Christina’s advisors and the closing agent to prepare for the sale of her property. Christina was able to net $60,000 after all closing costs, and the closing agent sent this entire amount directly to Christina’s QI.
It is important to note that Christina must use all of her equity in the property – including her original $20,000 investment, the $25,000 paid off of the mortgage balance, and the $15,00 in capital gain – toward the purchase of her replacement property to defer all taxes. This is because if Christina had sought to withdraw her initial investment, the IRS would have characterized those funds as profit rather than the return of her original investment. This would have created a taxable event, which Christina was seeking to avoid.
Christina spent the next several weeks working with her real estate advisor, knowing that she had 45 days to provide her QI with a short list of potential replacement properties. Read this article for more information about the identification rules.
Working with her real estate advisor, Christina found a newer 3-bedroom, 2½ bath townhouse, with a garage, on a quiet street in a desirable neighborhood. Using the $60,000 from the sale of her first condo, Christina financed the remaining $240,000 needed to complete the acquisition of the $300,000 townhouse. Christina’s QI again collaborated with her advisors and the closing agent, and Christina was able to complete the acquisition of her second investment within the exchange period. Read for more information about exchange deadlines.
Consolidating Kelly’s Portfolio
Like Christina, Kelly began investing in real estate right out of college. Over the years, Kelly has built a portfolio of six condos, townhouses, and single-family rentals in four towns near her home. But managing all of these properties was proving to be difficult and time consuming. Kelly wondered whether there was an easier way.
Kelly consulted with her tax and legal advisors, both of whom encouraged her to consider a Section 1031 exchange. Kelly’s portfolio is worth about $800,000, and if she were to sell outright, she would face about $275,000 in state and federal capital gains and depreciation recapture taxes. Kelly agreed that a 1031 exchange was the right way to go, and listed her properties with her local real estate agent. The listing indicated that they could be bought as a bundle, or individually.
Kelly also consulted with the QI that her advisors recommended. During the consultation, the QI pointed out that if she sold the various properties individually over a period of time, but still wanted to use the proceeds of all of them for one purchase, her identification and exchange periods would commence with the sale of the first property. The QI also pointed out that, depending on the timing of the sales, and the possibility that Kelly might want to acquire multiple replacement properties, Kelly could consider establishing multiple exchange accounts.
Fortunately, Kelly’s properties were all desirable, and her broker was able to secure one buyer for the entire portfolio. Kelly and her broker provided the sale contract to the QI, who prepared the necessary exchange documents. The QI worked closely with Kelly’s advisors and the closing agent to ensure that the net sale proceeds were sent directly to the QI rather than to Kelly or her attorney. At closing, the net proceeds of $700,000 (after expenses and paying off mortgage debt of just under $100,000) were sent to the QI, properly starting Kelly’s 1031 exchange.
Working with her real estate advisor, Kelly found a mixed-use, multi-tenant building near her home, consisting of two apartments, two stores, and three townhouses. Using the $700,000 in exchange proceeds, Kelly financed the remaining $900,000 needed to complete the acquisition of this property. (It is important to note that if Kelly wants the full benefits of a 1031 exchange, she would need to replace the debt paid off at the sale of her original property. Kelly obtained a new loan, but she also could have replaced the original debt with fresh cash. Further, Kelly is leveraging her equity to acquire a new property worth significantly more than the one she sold.) Kelly’s QI again worked closely with her advisors and the closing agent, and Kelly was able to complete the acquisition of her consolidated investment within the exchange period.
Grandpa’s Estate Planning and Diversification
Grandpa Al has owned a small shopping center for many years. He had no immediate need to sell the shopping center until he spoke with his new estate planning attorney. During the consultation with the estate planning attorney, Grandpa Al revealed that his Will provides that his four grandchildren will inherit the shopping center. The estate planning attorney pointed out that having four family members inherit one property was a recipe for a new family feud. He pointed out that the four grandchildren would likely have different ideas about what to do with the shopping center, and that he should consider restructuring his real estate investment. The estate planning attorney invited his tax attorney partner into the consultation, who educated Grandpa Al about 1031 exchanges.
Grandpa Al decided that he would sell the shopping center as part of a 1031 exchange. Working with his real estate advisor, Grandpa Al listed the shopping center for sale, and began looking for potential replacement properties.
Because the shopping center was well-maintained, and fully occupied, there were multiple offers. Grandpa Al promptly sought referrals from his tax and legal advisors for a QI. The QI worked closely with Grandpa Al’s advisors and the closing agent to prepare for the sale of the shopping center. Grandpa Al was able to net $1,000,000 after all closing costs, and the closing agent sent this entire amount directly to Grandpa Al’s QI.
Working with his real estate advisor, Grandpa Al found four identical condo units, within walking distance of the local university. Using the $1,000,000 in exchange proceeds, and some additional cash, Grandpa Al, completed the acquisition of the four condos for $1,100,000. Grandpa Al’s QI again worked closely with his advisors and the closing agent, and Grandpa Al was able to complete the acquisition of his newly diversified investment within the exchange period.
Grandpa Al then went back to his estate planning attorney to update his Will, so that each grandchild will inherit their own individual condo unit, and have the added benefit of a step-up in basis upon Grandpa Al’s death. This means that when Grandpa Al dies, his heirs will inherit the property at the fair market value as of the date of his death. Thus, there will be no depreciation recapture or capital gains to recognize.
Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property.