1031 Exchanges also called ‘like kind’ exchanges and ‘tax deferred’ exchanges are a process investors can use to defer paying capital gains tax, that they would normally pay on an ordinary sale, until some future date. 1031 exchanges are for investors only; home owners have an even better option available to them- the homeowner’s capital gains exemption (IRC Section 121).
Some people mistakenly refer to 1031 Exchanges as ‘tax-free exchanges’. Capital gains taxes are postponed in a 1031, but not avoided. You transfer the tax liability of the previous property over to the new property. When the replacement property is sold (not as part of another exchange), the original deferred gain, plus any additional gain is subject to tax.
1031 get its name from the IRS internal revenue code Section 1031 – which describes how these exchanges work.
The IRS considers a qualifying exchange not as a sale but a trade, of like kind property, and if all the conditions are met, the new asset is treated as if you’d owned it from day one— no gain, no loss, no taxable event taking place upon transfer.
1031 Exchanges are allowed in all states because it is federal tax law. You can sell a property in Texas and buy one in California as part of a 1031 exchange. Some states have special state laws affecting exchanges, so make sure you learn the state law before exchanging there. California follows the federal law. See Sections 18043 and 24941 of the California Revenue and Taxation Code. California doesn’t have any special tax rates for Depreciation Recapture or Capital Gains Tax, so your tax on these are the same as your California State Income Tax Rate. Questions about State laws for your 1031 exchange? Ask your 1031 exchange company.
Always talk with your accountant before deciding whether or not to do a 1031 exchange. If you are carrying a large business loss it might be better to write off the entire capital gain against the loss than do an exchange because you will be able to take more depreciation in the future and use up the tax benefits of the loss now.
If you are doing a 1031 exchange as a seller, put “buyer to cooperate with seller’s 1031 exchange” in the private listing remarks, and when you are the buyer, write in the purchase contract that you are buying the property “with proceeds from a 1031 exchange”.
Why do a 1031 Exchange?
-Defers Capital Gains Tax
-Defers Depreciation Recapture
-Allows you to Reinvest or “Roll” tax deferred dollars for increased buying power (interest free loan from IRS!)
-Penalty free way to move money from real estate investments to different markets or investment property types (ie move money from a management intensive property such as a vacation rental to a management free property such as a NNN Retail building)
-Remote possibility to eliminate Capital Gain Tax and Depreciation Recapture Tax entirely with Stepped up basis upon death through inheritance.
Let’s look at a detailed example of how much more buying power you get with a 1031 Exchange rather than selling and then buying:
You bought a 4 plex for $1M 10 years ago with 30% down and a 30 year fixed loan at 6% interest. Your original closings costs were $20,000. Other than doing routine maintenance, you made no capital improvements to the building while you owned it. Each year you held it you took the maximum depreciation (200K land value, 800K building- 800/27.5) of 29K per year. Over the ten years you held the investment, it appreciated 40% for a sale value of $1,442,000. You make over $250,000 a year in net income so your tax bracket is 12.3% CA and 39.6% Federal. You have just sold the property and plan to buying a bigger investment property that will produce more cashflow. The closing costs on this new sale are 6% of $1,442,000 = $86,520.
Original Purchase 10 Years Ago:
|Standard Sale||1031 Exchange|
|Original Down Payment||$300,000||Same|
|Original Mortgage @ 6% interest||$700,000||Same|
New Sale @ 40% Appreciation over 10 years
|Standard Sale||1031 Exchange|
|New Closing costs @ 6% of $1,442,000 = $86,520||$86,520||Same|
|Depreciation taken 29K *10 years||$290,000||Same|
|Adjusted Basis $1,000,000 original purchase price + $20,000 original closing costs + $86,520 new closing costs – $290,000 depreciation||$816,520||Same|
|Amortization of Loan Balance, currently $584,532||$700,000 – $584,532 = $115,468||Same|
|Gain||$625,480 ($335,480 Capital Gain + $290,000 Depreciation)||Same|
|Capital Gains Tax @ 20% Federal + 12.3% CA + 3.8% Medicare Surcharge = 36.1%||$335,480 * 36.1% tax=
$121,108 Capital Gain Tax
|Depreciation Recapture (12.3%CA + 25% Federal = 37.3%)||$290,000 * 37.3% tax =
|Proceeds from Sale||Sale Price $1,442,000 – loan repayment $584,532 – New Closing Costs $86,520 – Capital Gains Tax $121,108 – Depreciation Recapture $108,170 =$541,670||Sale Price $1,442,000 – loan repayment $584,532 – New Closing Costs $86,520 =$770,948|
|Cash into replacement property||$541,670||$770,948|
|Purchase Price of Replacement property Downpayment 30%||$1,805,000||$2,569,000|
To Summarize, the difference in buying power is:
There are Disadvantages to doing a 1031 Exchange:
-Can be hard to pull off
-Reduced basis in replacement property resulting from carryover of the basis of relinquished property.
-Lower Depreciation Deductions (not substantial if replacement property is more expensive)
-Business Losses can’t be used
Relinquished Property – The property that you sold to trade for the replacement property. It can also be called the downleg an exchange.
Replacement Property- The “second leg” of the exchange. It is the property you purchase to complete your exchange.
In a 1031 exchange the exchange must be like kind property. Like Kind means real estate for real estate. Any kind of real estate is considered “like kind” and can be exchanged for each other. For example you can trade vacant land, hotels and motels, farms, apartments, houses, office, retail, strip malls, gas stations, storage facilities, warehouses. Like Kind does not include personal property such as cars, machinery, patents.
To be eligible for a 1031 exchange, you may never “touch” the money, or your 1031 is void. You need a Qualified Intermediary (QI) to handle the money for you. They receive and disburse the proceeds of the sale. Most of the times your Qualified Intermediary is a 1031 exchange company. The IRS does not allow relatives, your accountant, attorney, real estate agent, or escrow company to be your QI.
Boot is the amount of profit and liabilities carried over from the previous property. You are not allowed to make a monetary benefit out of the exchange. Boot is taxed. To avoid being taxed, make sure the boot of the new property is equal to or larger than the boot of your old property. The IRS believes that if you are relieved from debt, or don’t reinvest 100% of the profits into the new property during an exchange that that is an economic benefit, and the difference is taxable. New boot needs to be greater than or equal to the old boot, or you pay taxes on the portion of boot that is uncovered. There are 4 types of boot: Price Boot, Cash Boot, Mortgage Boot, and Depreciation Boot.
Price Boot– you have to buy a property for the same selling price or higher.
Example (bought more expensive property), you sold a $500,000 property through an exchange and purchased a $700,000 property. There is no price boot.
Example (bought less expensive property), you sold a $500,000 property through an exchange and purchased a $350,000 property. $150,000 that is the difference in price is taxable.
Cash Boot- you have to reinvest all cash or you will be taxed on the remainder. Cash boot cannot be offset by Mortgage Boot.
Example You sold a $500,000 property through an exchange with $400,000 of Mortgage debt and received $100,000 cash. You purchased a $550,000 property with 10% down for $55,000. The Difference between the $100,000 in cash and the $55,000 reinvested would be taxable.
**IMPORTANT: If you want to take cash out let your QI know before you complete sale of the first property or you will have to wait until the end of the exchange (another 180 days) to get it.
Mortgage Boot– you have to take on an equal or larger amount of mortgage debt. Mortgage Boot CAN be offset by cash boot.
Example, You sold a $500,000 property through an exchange with $400,000 of mortgage debt and received $100,000 cash. You Purchase a $600,000 property with 50% down, for a $300,000 mortgage. Your mortgage boot is short $100,000 and would be subject to tax, except the cash boot of $100,000 can be used to offset and you will owe nothing.
Depreciation Boot– Since this property was an investment property, Depreciation has been taken. If the property you buy doesn’t have an equal or larger depreciable basis, you will be taxed for depreciation recapture of the difference.
Example, You have owned a $500,000 duplex for 10 years, that was $450,000 structure value and $50,000 land value. You were allowed to depreciate it $16,363 per year. In 10 years you took a total of $163,636 in Deprecation. You are exchanging this property in a $750,000 piece of vacant land. Since the land has $0 structure value, the depreciation boot will be recaptured and taxed at 25%. $163,636 x 25%= $40,909 in depreciation recapture tax.
Example 2, You have owned a $500,000 duplex for 10 years, that was $450,000 structure value and $50,000 land value. You were allowed to depreciate it $16,363 per year. In 10 years you took a total of $163,636 in Deprecation. You are exchanging this property in a $750,000 apartment building with $675,000 structure value. No Tax is due because $675,000 is greater than $450,000
Example 3 You have owned a $500,000 duplex for 10 years, that was $450,000 structure value and $50,000 land value. You were allowed to depreciate it $16,363 per year. In 10 years you took a total of $163,636 in Deprecation. You are exchanging this property in a $750,000 apartment building with $400,000 structure value. Since there is a $50,000 difference between the structure value, you will be taxed on Depreciation recapture on the $50,000.
How do I do a 1031 Exchange?
Make Sure that you are exchanging into a property that has a larger boot unless you are willing pay taxes.
Immediately after you close on your first relinquished property (if you are selling more than 1) the time line begins on the 1031 exchange. The time periods are very strict and cannot be extended even if deadline falls on a Saturday, Sunday, or legal holiday.
Identification Period 45 calendar days
You must identify the replacement property within 45 days of the sale of your relinquished property. This period of time is called the identification period. You can close on a property during the identification period which is why I always recommend to start writing offers as soon as you close.
Identification must be in writing, typically a 1031 exchange company has a property identification form that you fill out. It must be signed and delivered to the exchange company before the end of the 45 days. Verbal notice is not enough.
You have to buy a replacement property that was identified on your list to qualify. You may even identify property that is currently under construction.
3-Property Rule- You may identify up to 3 properties, of any value.
There are two rules that allow you to identify more replacement properties than 3 but you don’t want to!
200% Rule: You may identify as potential Replacement Property any number of properties provided the aggregate fair market value of all of the identified properties does not exceed 200% of the selling price of the relinquished Properties.
95% Rule: If you identify more Three properties that exceed 200% of the sale price of the relinquished property than you must buy at least 95% of the aggregiate fair market value of all the identified Replacement Properties.
Exchange Period 180 days
One of the three identified replacement properties must close the earlier of 180 days from Relinquished property sale date or the due date (including valid extension) of the tax return for the year in which the relinquished property was transferred.
1031 Exchanges can cost between $1,000-$2,000.
A Warning on 1031 Exchanges
1031 Exchanges encourages investors to buy up because you can only identify 3 replacement properties total and you need to buy a bigger property to avoid being taxed on boot. If you go from exchange to exchange to exchange getting bigger and bigger each time, you risk having the maximum exposure in the real estate market right before it is going to crash. Sometimes it is better cash out and pay the tax, than to get yourself overextended.