Maximize Capital and Realize Changing Investment Goals

As commercial and residential values skyrocket around the country, 1031 exchanges are becoming more attractive to certain taxpayers who are selling real property that has experienced significant appreciation in value.

1031 exchanges – so named for Internal Revenue Code Section 1031 – enable taxpayers to defer paying capital gains taxes on property they have sold, as long as they never constructively receive the proceeds from the sale and the proceeds are used to purchase qualifying replacement property in accordance with the provisions of the tax code. In order to qualify for 1031 exchange treatment, both the property sold (“relinquished property”) and the property purchased (“replacement property”) must be property either held for investment or used in a trade or business so this tax strategy does not benefit homeowners who are buying and selling primary residences. However, residential property that is purchased for use as a rental does qualify for 1031 exchange treatment.

History of 1031 Exchanges

The concept of a tax-deferred property exchange was created in 1921 to encourage Americans to reinvest at a time when the country was still recovering from the economic and social effects of WWI. In the century since, the exchange mechanism has been expanded and contracted numerous times, most recently by the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA restricted the applicability of the 1031 exchange by repealing the ability for taxpayers to exchange personal property. Before TCJA, taxpayers could exchange commercial vehicles, aircraft, and heavy equipment, among other things, to benefit from 1031 treatment. But since passage of the TCJA, only real property is eligible.

How a 1031 Exchange Works

The most common form of 1031 exchange is a deferred exchange whereby the taxpayer closes on the sale of the relinquished property before acquiring replacement property. There are other types of 1031 exchanges such as simultaneous exchanges, reverse exchanges and construction exchanges which are not described in this article. The mechanics of a basic deferred exchange are:

  • Taxpayers may not carry out a deferred 1031 exchange on their own. To qualify for 1031 treatment, a deferred exchange must be made through an unrelated intermediary party (“Qualified Intermediary”). Unrelated means the Qualified Intermediary cannot be a family member or have a business relationship with the taxpayer, among other rules. The Qualified Intermediary is paid a fee, so it’s important to budget for that.
  • When the relinquished property is sold, the proceeds from the sale are placed in escrow with the Qualified Intermediary – not the seller – to be used for the purchase of the replacement property.
  • From the date of closing on the sale of the relinquished property, the taxpayer has 45 days to identify qualifying replacement property and give notice to the Qualified Intermediary of the identified property.
  • The taxpayer has up to 180 days after the closing on the sale of the relinquished property to close on the purchase of identified replacement property.
  • At the closing on the purchase of the replacement property, the proceeds from the sale of the relinquished property held in escrow by the Qualified Intermediary are used to purchase the replacement property.

For taxpayers who are subject to large capital gains when they sell their commercial or investment property, a 1031 exchange enables them to realize the gain without recognizing it for tax purposes. The deferral of the capital gains taxes on the relinquished property lasts as long as the replacement property is held.

If the taxpayer were to die while still owning the replacement property, under current law the heirs would benefit from a step up in the tax basis of the replacement property to its fair market value as of the date of the taxpayer’s death, thereby legally avoiding paying income tax on the original gain on the sale of the relinquished property and any appreciation on the replacement property. To that extent, the 1031 exchange can be used as an effective estate planning tool.

 Frequently Asked 1031 Exchange Questions

  • How does a 1031 exchange affect state taxes?
    • Every state has its own tax rules, so if you are planning to exchange properties across state boundaries, work with an advisor who understands how your non-resident state will treat the exchange.
  • Can I exchange real property here in the U.S. for foreign property and qualify for 1031 treatment?
    • No. Congress changed the law in 1989 to disqualify 1031 exchanges involving foreign (non-U.S.) property.
  • Can I take cash out of a 1031 exchange?
    • It is rare that two properties have exactly the same market value, so one party in a 1031 exchange will have at least a small cash out. Cash taken out of a 1031 exchange is known as “boot” and is generally taxable. In order to fully benefit from a 1031, exchange the value of the replacement property should be greater than or equal to the value of the relinquished property.
  • Can I use a 1031 exchange to acquire a vacation house?
    • A common question. This only works if you convert the new beach house into a business property immediately and use it continuously as a business property – most likely a vacation rental – for at least two years.

If you are considering selling commercial or investment property and think a 1031 exchange may be an option for you, contact your Adams Brown advisor.