What is a 1031 Exchange?
Defer taxes when buying and selling commercial or investment real estate
Generally, the sale of a real property, such as an office building, rental house, apartment building or strip mall, is a taxable event which creates a tax liability to the seller. However, Section 1031 of the Internal Revenue Code allows for taxes to be deferred for a qualifying exchange of like-kind property, in which you buy one piece of real estate to replace another.
If you’re selling a business or investment real estate property and buying another, Section 1031 may enable you to defer capital gains and other tax liability on the transaction. But it’s crucial that the transaction be structured as an exchange that complies with “safe harbor” IRS regulations that apply to Section 1031 exchanges. Just remember: an exchange is eligible for tax deferral; a sale followed by a purchase is not.
The “Like-Kind” Requirement
One of the criteria for qualification under Section 1031 is that the two properties involved in the transaction must be “of like kind.” Thankfully, in the case of real estate, the “like-kind” requirement is very easy to satisfy — typically, any business or investment real property may be exchanged for any other.
Increased Purchasing Power
Using a Section 1031 exchange enables the seller to reinvest the cash from the sale that would otherwise be paid to the IRS into more or better property.
To demonstrate this, here’s a simple example assuming an individual taxpayer with a $2 million sale, a $1,200,000 gain, 5% closing costs, no indebtedness encumbering the property, and a 23.8% total effective tax rate*:
How to do a 1031 Exchange?
Choose JTC Americas as a Trusted QI for Your 1031 Forward or Reverse Exchange.
1031 exchanges enable you to reduce or eliminate taxes on the sale of business or investment real estate. If you want to sell one business or investment property and purchase a “like-kind” property within 180 days of the sale, structuring these two transactions as a 1031 exchange can enable you to avoid capital gains tax, depreciation recapture tax, and even sales tax. Using a Qualified Intermediary (QI) converts the sale and the purchase into an exchange and creates the opportunity for tax deferral.
There are two ways on how to structure a 1031 exchange: forward and reverse.
1031 Forward Exchange Process
1031 Forward Exchanges are the most frequently used type of 1031 exchange because of their versatility and ease and speed of implementation. Forward exchanges are characterized by the sale of the currently owned property (relinquished property) followed by (or simultaneous with) the purchase of the new property (replacement property).
Prior to the sale of the relinquished property, the exchanger and the QI enter into an exchange agreement and set up a qualified escrow account at a secure bank to hold the sales proceeds. Upon the sale of the relinquished property, the sales proceeds are wired to the qualified escrow account, which allows distributions only when authorized by both the exchanger and the QI. The funds are held in escrow until they are disbursed to buy the replacement property.
The exchanger has 45 days to identify replacement property in writing or to acquire replacement property without a written identification. If a written identification is made, the client has 180 days from the date of the sale of the relinquished property to complete the purchase of the replacement property.
1031 Reverse Exchange Process
A 1031 Reverse Exchange provides the same tax benefits as a 1031 forward exchange, but with one major difference: a reverse exchange enables you to buy first and then sell.
The IRS has issued guidance to provide “safe harbors” that enable exchangers to structure successful 1031 reverse exchanges. There are two basic types of reverse 1031 exchanges:
Exchange First, in which the QI acquires title to the relinquished property, as part of the exchange in which the exchanger acquires the replacement property, and “parks” it until the relinquished property can be sold.
Exchange Last, the most common form of reverse exchange, in which the QI acquires title to the replacement property and “parks” it until the relinquished property can be sold.
In an “Exchange Last” transaction, the exchanger has 45 days after the replacement property is parked to identify their relinquished property in writing or to sell their relinquished property without a written identification. If a written identification is made, the client has 180 days from the parking of the replacement property to complete the sale of the relinquished property.
What Rules Apply to 1031 Exchanges?
The rules that apply to Section 1031 exchanges come from a variety of sources, including federal statutes, federal regulations, court cases, and IRS guidance, such as revenue rulings, revenue procedures, and private letter rulings. It is important to choose a qualified intermediary (QI) that understands these rules, so that you can achieve your goal of tax deferral. The attorneys and staff at JTC Americas have decades of experience working with and complying with these rules. These rules are summarized below according to the type of exchange.
In addition to the basic requirements that an exchanger acquire property that is like kind to the property that is sold and that both the relinquished property and the replacement property are used for business or investment purposes, the most important rules applicable to forward exchanges are the rules around timing, identification of replacement property, and the use of a QI.
Timing rules are critical to a successful Section 1031 exchange. If these rules are not met, then an otherwise successful exchange will fail to qualify for tax deferral.
The exchanger has 45 days from the date of the sale of his property to identify replacement property in writing in accordance with the requirements specified in the regulations. If the exchanger acquires replacement property without identification within the 45 day period, it is deemed to have been identified.
Identified replacement property must be acquired within 180 days after the sale of the first relinquished property sold as part of the exchange.
For property acquired after the 45th day, one of the following identification rules must be satisfied in order for the replacement property to qualify:
- Any 3 properties can be identified, regardless of their individual or aggregate fair market value
- Any number of properties can be identified, provided that their aggregate fair market value does not exceed 200% of the value of all the relinquished properties
- Any number or value of properties, provided that the exchanger acquires property of a fair market value which is at least 95% of the aggregate fair market value of all properties identified
IRS regulations provide very specific guidance on how to transact a “safe harbor” exchange. Prior to the exchanger generally enters into a written agreement with a QI, which creates the “exchange” that enables the exchanger to obtain tax deferral treatment for the sale of his relinquished property.
Under the regulations, a QI must also be assigned the exchanger’s rights, but not his obligations, to the relinquished property sale agreement and to the replacement property purchase agreement in order for those properties to be transferred directly to the buyer or seller. The other parties to each agreement must notified of such assignments prior to the transaction covered by that agreement.
A QI must not be a “disqualified person.” The regulations provide that these types of relationships will violate the disqualified person rules:
- Any person who acts as the agent of the exchanger at the time of the exchange, including someone who has acted as their employee, attorney, accountant, real estate agent or broker or investment banker or broker during the 2 year period ending of the date of the transfer of the first relinquished property
- Any person related to the exchanger within the meaning of IRC Section 267(b) or 707(b), which includes certain types of close relationships among family members, partners, partnerships, shareholders, corporations, beneficiaries, trustees, and executors
- Any person related to an agent of the exchanger within the meaning of IRC Section 267(b) or 707(b) using a 10% test instead of the 50% test
Security arrangements, such as qualified escrows and trusts administered by a bank, are typically used in addition to the QI to maximize exchange funds security.
A reverse exchange always involves both a forward or simultaneous exchange and a parking arrangement. A parking arrangement can be used to park either the relinquished property as part of an “Exchange First” reverse exchange or the replacement property as part of an “Exchange Last” reverse exchange.
Parking arrangements are either “safe harbor” parking arrangements that satisfy the conditions of IRS Revenue Procedures 2000-37 and 2004-51 or non-safe-harbor parking arrangements that do not meet conditions of the revenue procedures. A safe harbor parking arrangement has the advantage of providing the certainty that the IRS will not challenge the parking arrangement, which is an integral part of making a reverse exchange work. But the disadvantage of a safe harbor parking arrangement is that the parked property cannot be parked more than 180 days.
In safe harbor parking arrangements, the exchange accommodator, called the exchange accommodation titleholder or EAT, enters into a qualified exchange accommodation arrangement (QEAA) with the exchanger, holds the title to the parked property, typically in a single member limited liability company, until the property is either transferred to the exchanger, in the case of parked replacement property, or sold to the unrelated buyer in the case of parked relinquished property. Frequently, as is allowed under the revenue procedures, the exchanger will lease, or build improvements on, the parked property during the parking period. Identification rules analogous to the those of forward exchanges apply to the identification of relinquished property for Exchange Last parking arrangements.
The structure for non-safe-harbor parking arrangements is similar to that of safe harbor parking arrangements except that there is no specific limitation on the length of time that the property can be parked or rules on who may hold the parked property. There is very little guidance on non-safe-harbor parking arrangements other than a 2001 IRS private letter ruling and the 2016 Estate of Bartell v. Commissioner Tax Court case, both of which are taxpayer favorable. The IRS chose not to appeal the Bartell decision to the federal appellate court, but it did issue a nonacquiescence, expressing its intention not to follow Bartell.
These rules are the principal rules applicable to the two main types of Section 1031 exchanges, but there are many other highly nuanced rules that may apply depending upon the exchanger’s situation. Some of these rules involve liability (mortgage) netting, sales to or purchases from persons or entities related to the exchanger, “drop and swaps” and domestic versus foreign property exchanges. Again, whether or not these issues present a challenge to the exchanger depends upon the exchanger’s tax situation and the complexity of the exchange.
Think you are ready to start your first 1031 Exchange? Read Your First 1031 Exchange: 5 Things You Need to Know
Learn more about JTC’s 1031 Exchange Services
Interested in finding out more about 1031 exchanges? One of the key elements of the IRS 1031 regulations is the use of a qualified intermediary (QI) to facilitate the exchange. One of the most important steps towards a successful exchange is selecting the right QI.
At JTC, we’ve put together an industry-leading track record of 1031 success, with tens of thousands of transactions and more than 25 years in the business. Our legal and Client Services teams’ experience in accounting, banking and technology sets us apart. We can handle large and complicated exchange scenarios that many QIs can’t. And we’ve built a cutting-edge administration platform, called eSTAC®, from the ground up to maximize transaction security, transparency, and compliance.
Want to learn more about JTC and our services, then visit our 1031 Education Center or read the articles below!