Everything you need to know about tax-deferred exchanging — from basics to advanced strategy.
Often called the last great wealth-building tool available to real estate investors, a tax deferred exchange is an IRS-approved approach where a property owner can sell a highly appreciated asset and replace it with another like-kind property on a tax deferred basis, provided the transaction is completed within basic IRS guidelines.
Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase, an exchange is different because the entire transaction is memorialized as an exchange and not a taxable sale. This distinction is what allows the taxpayer to qualify for deferred gain treatment. Essentially, sales are taxable and exchanges are not.
The first and most obvious reason is that the normal capital gains tax traditionally due upon a sale can be deferred until a later date and a later sale. The IRS allows this because they view it as transferring your cost basis from one qualifying property to another.
Other reasons to consider an exchange include: exchanging into a better property or location, exchanging into better investment circumstances, diversifying equity across new replacement properties, deferring depreciation upon a sale, and constructing or improving new replacement property.
The IRS expects you to replace both your equity and your debt to create a fully tax deferred transaction. To ensure your exchange will be totally tax deferred, do these three things:
1. Buy replacement property equal to or greater than the net selling price of your relinquished property. 2. Move all the equity from the old property into the new replacement property. 3. Replace your debt — if you have a $200,000 loan on your old property, make sure you have at least $200,000 in debt in your replacement property.
The IRS has set forth a few requirements for an exchange to qualify for deferred gain treatment. All properties must be like-kind — held for investment or in the productive use of a trade or business. You must identify potential replacement properties within 45 days and close on all replacement properties within a 180-day exchange period. You must use an independent Qualified Intermediary.
When identifying replacement properties, you must use one of three identification rules: The Three Property Rule (identify three properties of any value); The Two Hundred Percent Rule (if four or more properties are identified, their aggregate value may not exceed 200% of the relinquished property's value); and The Ninety-Five Percent Exception (the exchange still qualifies if you acquire at least 95% of the aggregate value identified).
The Simultaneous Exchange: Both the relinquished and replacement property must close and record on the same day.
The Deferred Exchange: The most common type. The relinquished property is sold at Time 1, and after a delay of up to 180 days, the replacement property is acquired at Time 2.
The Reverse Exchange — Buying Before You Sell: An Exchange Accommodation Titleholder (EAT) holds title to the replacement property until the relinquished property is sold.
Improvement and Construction Exchanges: When the replacement property requires construction or improvements, payments to contractors are made by the Qualified Intermediary out of trust account funds.
Since exchanges involve a minimum of two properties — often many more — they include extraordinary logistics due to multiple closings and many transactional moving parts. Because significant deferred gain treatment is at stake, every exchange deserves to be planned beforehand.
It usually only takes a few minutes with a 1031 professional to walk through the entirety of the exchange logistics before starting. This pre-planning can help you avoid pitfalls and create workarounds before any problems arise.
The process of selecting a Qualified Intermediary has never been more important. With relatively few federal regulations governing intermediaries, how a QI handles the facilitation of your exchange — and, most importantly, your exchange funds — is critical.
Select the facilitator as you would an attorney for personal representation or a physician to treat your children. Look for experience and reputation in the real estate, legal, or tax communities. Ask about the security of your funds and what options you have to ensure they are safeguarded.
Many exchangers don't understand that the 1031 industry is largely unregulated. There are few legislative provisions ensuring your exchange and your hard-earned funds are handled appropriately.
Segregated accounts are the bedrock of a secure, IRS-compliant exchange — keeping exchange funds entirely separate from the QI's assets. Qualified Escrow Accounts set up in the exchanger's name and tax ID let you see account activity and require written instructions for any movement of funds.
Get the complete Informed Exchanger guide with worksheets, checklists, and the questions worth asking any facilitator.