Understanding 1031 Exchanges
A 1031 exchange, or like-kind exchange (LKE), allows you to defer various forms of taxes—including capital gains, depreciation recapture, and state tax in most states. You can be eligible for a 1031 Exchange when you sell real estate that meets these requirements.
Like-Kind Requirement
Generally, all real estate is like-kind to other types or kinds of real estate. For example, an apartment building could be exchanged for a retail center.
Use of a Qualified Intermediary
An unrelated third party or Qualified Intermediary (QI) may be used to facilitate the 1031 exchange transaction. A taxpayer cannot utilize their realtor, lawyer, accountant or a related party, or agent as a QI. Additionally, several states require that QIs be compliant with regulatory requirements regarding insurance, bonding, and the manner in which exchange funds are held, state licensing, etc.
Time Limits & Identification Requirement
A taxpayer is required to acquire or identify the target replacement property within 45 days after the transfer of the relinquished property. A written document that recognizably identifies the replacement property must be signed by the taxpayer and received by the Qualified Intermediary on or before the 45th day. Properties acquired within the 45-day designation period are deemed to be identified.
A taxpayer has 180 days (or the due date for filing of taxes for the year the property was sold) to acquire the replacement property. For example, if the relinquished property is sold in December, the due date for filing the tax return for that year would be less than 180 days. In such case, it would be necessary for the taxpayer to file for a tax-filing extension in order to utilize the full 180 days.
1031 Exchange
important tips
45
days
You have 45 days after the sale of your relinquished property to identify your replacement property(ies). Identification of replacement properties must be unambiguous, using a legal description or physical address. It must be in writing, dated, signed, and received by your QI within the 45 days. The 45-day requirement is strictly enforced with no option for extension.
180
days
You have 180 days after the sale of your relinquished property to purchase your replacement property(ies). The 180-day requirement is strictly enforced with no option for extension. Additionally, your replacement period could be shorter if your tax return due date is prior to the expiration of the 180 days, if that is the case you will want to file an extension on your tax filing.
ID
rules
The IRS provides three rules in which you can identify your replacement property(ies). The most common being the 3-property rule, simply put you can identify three properties. The 200% rule allows you to identify more than three properties so long as the fair market value of all properties does not exceed 200% of the sales price of your relinquished property. Lastly, the 95% rule states that should you over identify the first two rules then you have to purchase 95% in value of what was identified.
Like
kind
For a 1031 exchange to be valid, your properties must be like-kind. As it pertains to real estate, all real estate is like-kind to other real estate. Some examples would include: an apartment complex exchanged for a cell tower easement; an office building for farmland; or a rental home for water rights. Generally speaking, the only real estate that does not qualify under a 1031 exchange is a vacation home and personal primary residency.
ID
rules to
purchase
You have the option to purchase one or all of the properties you identified; you are not required to purchase all identified properties. Identifying more than one property just provides you with more options to ensure you have a replacement property within the 180-day exchange period. Additionally, you need to state how many properties you plan to purchase.
Reverse (Parking) 1031 Exchanges
A Reverse or Parking Exchange is where an Exchanger purchases their Replacement Property prior to selling their Relinquished Property. The typical order of events in a 1031 Exchange occur in reverse, hence the name.
Process of a Reverse Exchange
In order to have a valid Reverse Exchange, the Exchanger cannot own the Relinquished Property and the Replacement Property at the same time. Therefore, the transaction must be structured such that they sell the Relinquished Property prior to acquiring the Replacement Property. Typically, this is accomplished by having an “Exchange Accommodation Titleholder”, or EAT, acquire the Replacement Property. The EAT will hold title to the Replacement Property in a Reverse Exchange until the Exchanger sells the Relinquished Property, at which time the EAT then transfers the title back to Exchanger to complete the Reverse Exchange process.
Other Considerations in a Reverse Exchange
Some additional considerations for a Reverse Exchange include determining which property to “park” with the EAT. When parking the Replacement Property with an EAT the amount needed to acquire the property is a certain sum; however, if you are parking the Relinquished Property the amount is usually a best guess, which later requires adjustments to deal with the deviations. Therefore, traditionally the Replacement Property is “parked” with the EAT in a Reverse Exchange.
Some reasons why a Relinquished Property would be “parked” include:
Reasons For A Reverse Exchange
Competitive Real Estate Market
In a competitive market, finding suitable Replacement Property within the 45-day Identification Period can be difficult. A Reverse Exchange allows for the Replacement property to be identified and purchased prior without consideration of a 45-day regulation.
Ongoing Business
If the Exchanger operates their business in the Relinquished Property, they typically cannot shut down operations during the time it takes to acquire the Replacement Property. Acquiring the Replacement Property first allows them to relocate their business in a manner that minimizes business interruptions.
Financial Considerations
If an income-generating Relinquished Property is sold first, then income ceases until the Replacement Property is identified and purchased which could take up to 180 days with a traditional 1031 Exchange. Acquiring the Replacement Property first would allow the Exchanger to continue to generate income on the Relinquished Property, as well as potentially on the Replacement Property through a Reverse Exchange.
Timing Doesn’t Work
Sometimes the seller of the Replacement Property insists on the transaction occurring on or before a particular date, but the buyer of the Relinquished Property cannot complete the acquisition by that date. While the Exchanger hadn’t planned on a Reverse Exchange, the structure can save potentially thousands of dollars in taxes or other costs.
Build-to-Suit & Improvement Exchanges
A Build-to-Suit Exchange (BTS) is where an Exchanger purchases land to build the desired structure as the Replacement Property. An Improvement Exchange entails the Exchanger purchasing Replacement Property with the intention to improve the structure. Once the Exchanger takes title to the property, any improvements are considered payment for labor and materials and such payment is not the purchase of like-kind property.
Process of a Build-to-Suit/Improvement Exchange
In order to have a valid Build-to-Suit/Improvement Exchange, the Exchanger must utilize the exchange funds for the construction or improvement costs within the 180-day exchange period. They do not need to be completed during this period. Similar to a Reverse Exchange, an Exchange Accommodation Titleholder (EAT) creates a Special Purpose Entity (SPE), typically an LLC, to take legal title to the property during the period of construction. The SPE will take title to the Replacement Property on behalf of the Exchanger and “park” the title until the earlier of the construction or improvements are completed OR the 180th day. Once the EAT transfers ownership of the property to the Exchanger, the Exchanger has acquired improved like-kind real estate including the increased value of the improvements.
Other Considerations
Build-to-Suit and Improvement Exchanges can be set up on a forward or reverse basis. If the Exchanger sells the Relinquished Property prior to acquiring the Replacement Property then a forward type parking arrangement would occur and the EAT would fund the cost of the property acquisition and improvements from the exchange funds held from the Relinquished Property sale.
Alternatively, if the Exchanger acquires the Replacement Property prior to the sale of their Relinquished Property, a reverse parking exchange would occur and the Exchanger would have to provide the EAT funds personally for property acquisition and improvements or arrange for a bank loan. In either case, the loan would be paid back at the time the Exchanger sells the Relinquished Property and funds the exchange account.
Reasons For Build-to-Suit or Improvement Exchanges
Utilize All Exchange Funds
The primary reason to utilize these types of exchanges is to be able to utilize all the funds in the exchange account. Often the purchase price of the Replacement Property is less than the sale price of the Relinquished Property. The cost of the desired improvements can be made with the excess funds enabling the Exchanger to avoid “boot” and a taxable event.
Competitive Real Estate Market
In a competitive market, finding desirable Replacement Property within the 45-day Identification Period can be difficult. Build-to-Suit/Improvements Exchanges allow for a larger pool of potential Replacement property given the ability to customize the property as needed.
Meet Specific Criteria
Frequently a BTS is used when the Exchanger has specific criteria for the business use property, such as a factory or place of business, and is unable to find a pre-existing property that fits those needs so the Exchanger must construct or improve to satisfy the specific property requirements.
Cost Savings
Sometimes the Exchanger is able to find vacant property that can be acquired and constructed at a cost less than the sale price of a comparable already constructed property.