The Basics of 1031 Exchanges of Real Property by Yovanny Hernandez, CPA

2024-06-18

U.S. tax laws provide domestic and foreign real estate investors and developers with some of the most generous tax breaks, including the deferral of capital gain tax on the sale of highly appreciated property. This benefit of a 1031 exchange requires taxpayers to follow a unique set of rules and regulations. What is a 1031 […]

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What is a 1031 Exchange?

Internal Revenue Code Section 1031 allows taxpayers to defer capital gains tax on the sale of real estate property used for business or held as an investment when they reinvest the sales proceeds into a similar or “like-kind” property of equal or greater value. In other words, taxpayers can sell a long-held, highly appreciated investment or rental property with a low tax basis and put that money into another real estate asset held for investment or business use, thereby allowing their original investment to continue growing tax-free.

Taxpayers will owe capital gains tax if they sell a property without reinvesting the profits through a 1031 exchange. However, if they pass away holding the investment, the property will receive a step up in its cost basis to the fair market value on the owner’s date of death. At that point, the owner’s beneficiaries will inherit the property at the stepped-up basis and can choose to sell it at that price free of capital gains tax.

What is the Definition of Like-Kind Property?

The law broadly defines like-kind property as that which taxpayers hold for investment or productive use in a trade or business. While replacement property must be similar in nature or class, it need not be of the same quality as the original property. For example, you may swap a residential condo building in Florida for an office building in New York or a retail complex in Texas for unimproved land in California. Also permitted is the exchange of investment property for real estate used in a business or trade. However, taxpayers should note that they may not exchange property in the U.S. for real estate outside the country or vice versa.

What are the Timing Restrictions on 1031 Exchanges?

In a perfect world, taxpayers would relinquish one property on the same day they reinvest the sales proceeds into a replacement property. However, this is rarely the case. Instead, the law grants taxpayers limited time to complete both transactions in a deferred exchange and still qualify for tax deferral benefits.

Specifically, taxpayers must identify replacement property/properties of equal or greater value than the relinquished property within 45 days of the original property sale date. They are also required to complete the acquisition of replacement property/properties within 180 days from the date of the initial property sale. Failure to meet these deadlines will invalidate the exchange and require any sales proceeds to be returned to you.

On a final note regarding the timing of a 1031 exchange, the law also allows taxpayers to receive the benefit of capital gains tax deferral when they purchase replacement property before selling a property they intend to relinquish. With this reverse 1031 exchange, you transfer the title of the replacement property to a third party until you sell the relinquished property, which must be completed within 180 days of the replacement property purchase.

How Can I Get Started with a 1031 Exchange?

One way taxpayers can ensure they comply with all of the requirements of a successful 1031 exchange is to work with a team of professional advisors. While this may include your accountants and tax advisors, attorneys and real estate agents, the law requires you to engage the services of a qualified intermediary (QI) to receive, hold and transfer the funds involved in each transaction and help to guide you through the entire process. At no point should the taxpayer receive or exchange the proceeds from the original property sale.

The QI is identified on the HUD-1 settlement statement as the seller of the relinquished property and responsible for holding the net sales proceeds until the taxpayer completes the exchange within the allotted period. Once the taxpayer identifies the replacement property/properties, they assign the purchase contract to the QI, who acts as a buyer, transferring the proceeds from the relinquished property sale to the replacement property seller.

In the case of a reverse 1031 exchange, the taxpayer transfers ownership of the replacement property to an exchange accommodator titleholder (EAT) until they sell the original property within the 180-time allotment.

About the Author: Yovanny Hernandez, CPA, is a senior manager of Tax Services with Berkowitz Pollack Brant Advisors and CPAs, where he provides tax, business and compliance services to real estate businesses and individual investors. He can be reached in the CPA firm’s Miami office at (305) 379-7000 or info@bpbcpa.com.