The Complete 1031 Exchange Guide

Free quick-reference cards: six one-page summaries covering the 45-day and 180-day periods, identification, exchange funds at closing, and who can act as intermediary. Enter your name and email and they open on the next page.

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What Is an Exchange? Why Should an Investment Property Owner Consider an Exchange? 1031 Exchange Math — Full Deferral IRS Requirements & IRC Section 1031 The Most Popular Types of Exchanges 1031 Exchange Planning & Logistics Selecting a Qualified Intermediary The Security of Your Personal Data & 1031 Funds Glossary of Terms Free quick-reference cards

What Is an Exchange?

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 appreciated real property held for investment or business use and replace it with like-kind real property on a tax deferred basis, provided the transaction is completed within basic IRS guidelines. Since exchanges completed after December 31, 2017, §1031 applies only to real property held for productive use in a trade or business or for investment (IRC §1031(a)(1); T.D. 9935).

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. A 1031 exchange defers tax. It does not erase it.

Why Should an Investment Property Owner Consider an Exchange?

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.

1031 Exchange Math — Full Deferral

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 the debt — either with new debt or with additional cash brought to closing. Any reduction in debt that is not offset this way is treated as boot (Treas. Reg. §1.1031(d)-2).

IRS Requirements & IRC Section 1031

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 the exchange period, which ends at the earlier of 180 days after the transfer or the due date, including extensions, of the return for that year. A qualified intermediary is a safe harbor under Treas. Reg. §1.1031(k)-1(g)(4): if its requirements are met, the exchanger is treated as not in actual or constructive receipt of the funds. It is the structure used in nearly all deferred exchanges, but it is not the only one the regulation provides.

When identifying replacement properties, an identification must satisfy one of two rules, with a third provision that can save an over-identification: The Three Property Rule (identify three properties of any value); The 200% Rule — any number of properties, provided their aggregate fair market value at the end of the identification period does not exceed 200% of the aggregate fair market value of the relinquished property at transfer; and The 95% Exception — if both rules above are exceeded, the identification still holds if the exchanger acquires at least 95% of the aggregate fair market value of everything identified.

An identification must be in writing, signed by the exchanger, and hand delivered, mailed, faxed or otherwise sent before midnight on day 45 to the person obligated to transfer the replacement property or to another party to the exchange who is not the exchanger or a disqualified person (Treas. Reg. §1.1031(k)-1(c)(2)).

The Most Popular Types of Exchanges

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 within the exchange period, 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.

1031 Exchange Planning & Logistics

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.

Selecting a Qualified Intermediary

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.

The Security of Your Personal Data & 1031 Funds

Many exchangers don't understand that there are relatively few federal regulations governing intermediaries; some states, including California, regulate exchange facilitators (Cal. Fin. Code §§51000–51015).

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.

Glossary of Terms

Cost Basis

Your original cost in acquiring a property. If the original purchase price was $275,000, your cost basis is $275,000.

Adjusted Basis

Your current basis at the time of sale — the original cost basis plus improvements, less any depreciation previously reported.

Capital Gain

'Realized Gain' reflects the difference between total consideration received and the adjusted basis. 'Recognized Gain' reflects the portion of realized gain that is ultimately taxable.

Net Sales Price

The sales price, less costs of sale.

Net Purchase Price

The purchase price, less costs of purchase.

Boot

Cash, other non-like-kind property, or net debt relief received in the exchange. Boot causes gain to be recognized, but only up to the smaller of the boot received or the gain realized (IRC §1031(b)). There are two types: mortgage boot and cash boot.

New Adjusted Basis

The necessary adjustments to your basis after the replacement property is acquired, accounting for the amount of deferred gain.

Ready to start an exchange? Call 866-550-1031, or get the quick-reference cards below.