Owners of U.S. investment or business properties should know about a key tax-deferral provision allowed by the Internal Revenue Service: the 1031 exchange. Also called a like-kind exchange, it’s a way of swapping one investment property for another.

Upgrading to a more valuable investment property would usually involve a taxable sale. But by carrying out a like-kind exchange under Section 1031 of the Internal Revenue Code, the property owner defers capital gains taxes. This leaves more value for the investor to put into a replacement property.

Like-Kind Exchanges: The Basic Idea

Perhaps you own a rental townhome. It has appreciated $100,000 in value since you bought it. Now, you want to acquire a new, more valuable property. Normally, you’d have to sell, then buy, and owe tax on the capital gains of $100,000 on the property you sold. But that tax can be deferred if you trade up for a more valuable property, rather than buy afresh, so you’re not realizing the capital gains.

How does this work? Professional accommodators help investors find replacement properties and handle the transactions on their behalf. The firm deploys a qualified intermediary to buy the replacement property from the proceeds of the old investment property — making sure their client investors do not handle the cash.

Here’s a step-by-step timeline of the process:

Step 1: Select a Qualified Intermediary.

The Iowa-based Federation of Exchange Accommodators, a trade group for 1031 exchange facilitators, offers an online directory listing their members’ 1031 exchange firms. A tax expert with Section 1031 experience or your real estate attorney may be able to refer a firm they know. The firm you hire will create an agreement with you in order to have your property transferred to, and then from, the intermediary as a Section 1031 exchange.

Step 2: Complete Your Current Sale.

Carry out the closing on the property to be replaced. Sale proceeds go to the qualified intermediary upon closing, to be held in escrow until you’re ready to close on the replacement property.

Never claim a Section 1031 exchange if you have received cash proceeds from your property sale.

Step 3: Have the Intermediary Locate a Replacement Property.

The intermediary can locate rental or commercial properties that match the value you have in mind, and prepare to handle a purchase agreement with a 1031 provision.

Step 4: Identify Potential Replacement Properties Within 45 Days.

Designate, in writing, the potential properties the intermediary may buy — generally up to a limit of three options. It’s best to avoid designating cheaper replacement properties (or saving money on the mortgage when making the leap), as the IRS would tax the cash boot at the capital gains rate. Boot is the difference in prices between the exchanged properties.

Step 5: Close on a Designated Replacement Property Within 180 days.

Beyond the 45-day identification period in Step 4, you have the exchange period. All told, there’s a 180-day limit from the closing on your prior property’s sale to the date you close on your replacement purchase.

While the deed of the new property will go to you, the qualified intermediary uses the proceeds from the sale of your prior property to buy the new property from its seller. Professional fees can come out of the exchange funds. Taxes and financing charges must be paid separately. (Repairs and improvements made after closing are not within the exchange.)

Step 6: Use the New Property as Another Investment or Business Property.

Hold and use the replacement property for business. Voilà! You have just used tax-deferred funds, and spent them on a new, productive asset.

In a reverse exchange, the replacement property is bought before the prior property is sold. The exchange accommodation firm holds the title to the new property during the exchange process. Otherwise, the steps are similar.

Benefits and Risks

In addition to what we’ve noted above, there are clear benefits to reap from a 1031 exchange. To list just a few:

• Investor-owners can exchange one property into a second property into a third property, and so on. The investor may continue to acquire ever more valuable properties, with down payments supported by the capital gains tax deferrals. There’s no legal limit to the chain and its tax deferral opportunities, as long as Section 1031 rules are followed.

• The investor may take a loan out on the asset acquired in an exchange. This can result in tax deductions on the interest payments.

But on the other side of the coin:

• Investors who exchange properties must pay for the qualified intermediaries’ services, and can wind up paying too much for replacement properties because they’re rushed to beat the 180-day deadline for closing.

• At some point, the investor might need to make a regular sale. Should this occur, the property will be taxed on all accumulated gains in the chain of exchanges.

An investor who keeps trading up can plan a soft eventual landing. Consider the investor-owner whose latest acquisition would make a great primary residence. The owner oversees the property as a rental for two years to demonstrate the good-faith investment property exchange. The owner lives in the home another two years, and then qualifies for a capital gain exclusion.

This is a hypothetical case, and such plans should not be formulated without the guidance of a tax expert or a real estate lawyer.

Death and Taxes, Revised—By the 1031 Exchange

Investors may hold their final exchanged investment property until they pass away. The title then passes to tax-advantaged heirs by way of vesting into tenancies in common. The beneficiaries receive a stepped-up tax basis on assets from a taxable estate, averting substantial taxes on capital gains and recapture.

What is recapture? Generally, taxable profit on a property is adjusted as: (a) the cost of the original purchase; plus (b) capital improvements; minus (c) depreciation, also known as wear and tear, of a business property. The IRS may “recapture” value at income tax rates when properties sell for over their depreciated worth. So, recaptured depreciation is costly for a taxpayer, and it tends to rise over time. A carefully planned 1031 exchange can avert recapture.

Recapture and capital gains taxes are complex. Be sure you are putting your property to its best use if you are holding exchange properties as a form of estate planning. Consult a tax expert experienced with Section 1031 exchanges to assist you.

Know the Rules for Trading Up

The IRS refers to an exchange property as like-kind property. It interprets the term broadly, deeming U.S. investment or commercial properties as interchangeable investments. Exchange accommodators firms exist to draft legal documents compliant with IRS law, rules and policies.

Investor-owners should heed a few preliminary tips and rules before hiring a firm:

• Steer clear of companies suggesting exchange transactions for nonqualifying second homes, warns the IRS, and be wary of promoters of so-called “tax-free” exchanges. As the IRS points out, these exchanges are categorized as tax-deferred — not tax-free.

• Investors may not promptly convert a property acquired by exchange into a primary home and claim capital gains tax exclusions. Although there is no legal minimum time for the replacement to serve as an investment property, investors typically devote exchange properties to business use for at least a year — preferably longer, so as to avoid even the appearance of improper intent.

• LLCs, partnerships or accredited tenancy-in-common investor groups present more complicated fact sets. It’s important to have experienced professionals involved at every step.  

In Short…

Section 1031 rules and customs must be understood and followed with care. Otherwise, investors can wind up responsible for back taxes, plus penalties and interest. A 1031 exchange is a powerful wealth-building tool, yet to follow the law means enlisting professional planning and guidance.

Supporting References

26 U.S. Code § 1031: “Exchange of Real Property Held for Productive Use or Investment.” Readers are referred to the IRS Fact Sheet on Section 1031 of the U.S. Internal Revenue Code for additional help and information.

Photo credit: (lead image) and Francesca Tosolini, via Unsplash.