Written By: Whitney Nash, President/CEO/Qualified Intermediary at Above & Below 1031 LLC and Member of CCAR's Affiliate Committee.
As a client’s trusted advocate throughout a real estate transaction, real estate agents are likely to receive questions about 1031 exchanges or may recognize that a client might benefit from doing one because of their situation. There are many details and nuances to consider and a lot of misconceptions out there about the rules that must be followed. To help guide your clients, here are the most important things to know so that they may successfully execute and maximize the tax benefits of doing a 1031 exchange.
For a valid 1031 exchange, your client needs to have a Qualified Intermediary (QI) involved and an exchange agreement in place with them before the relinquished property (the property they are selling) closes. Once the sale is closed, it is too late. Many people believe that they can close on the property they are selling and either have the title company hold the proceeds or hold the proceeds check themselves without depositing it, and still do a 1031. They cannot begin a 1031 after the property has closed, even if the proceeds have not been deposited. They must plan in advance. Same day is possible, but not recommended. The best time to open an exchange is soon after the property goes under contract.
Your client can have 1031 language in the sales contract, but it is not required. Giving the buyer or seller the heads-up that your client will be doing a 1031 exchange on your side of the transaction leads to fewer surprises but does not have to be included in the contract because it does not affect them. Many QIs provide a “Notice of…” letter for the buyer and seller on each side of the exchange to satisfy this professional courtesy.
In a standard deferred (aka forward) 1031 exchange, your client must sell their relinquished property before they acquire the replacement property (the property they want to buy). However, if they find and must close on their replacement property before they can close on their relinquished property, your client may still be able to do 1031, but will need to do a reverse exchange instead. This is typically much more expensive than a standard/forward exchange because it is much more complicated. It also requires additional preparation time to open the reverse exchange.
Your client can have more than one relinquished property and more than one replacement property. 1031 exchanges are a great strategy to use when someone is trying to grow a portfolio or downsize into fewer properties. For example, the proceeds from one single-family home rental can be split up to buy 2-3 new SFH rentals. Or, 4 SFH rentals can have the funds put into the same exchange to buy 1 commercial office building. The 45-day and 180-day rules and deadlines (information to follow) must be adhered to properly for this to work.
When doing an exchange, the relinquished and replacement properties must be “like kind” “real property” to each other. Generally, all “real property” is like kind to other “real property”. For example, a single-family home can be exchanged for vacant land, a commercial building, oil & gas mineral rights, a DST, etc. and vice versa. Any combination is acceptable.
Investments that are not considered like kind real property are: REITs and other stocks, ownership interest in an LLC or partnership, personal property, collectables, etc.
Though the definition of like kind real property is fairly broad, the way that the properties on both sides of the exchange are used matters for qualification purposes. Both must be “held for investment or use in a trade or business for a period of time”. They cannot be held for personal use or as inventory. The amount of time is vague, but 2 years or more is usually considered safe, 1+ years would depend on several factors, less than 1 year would not be advisable except in a few instances. Basically, your client can’t do a 1031 exchange on properties that fall into one of the three following uses:
- A property that is used as their primary residence; or
- A property that is a personal-use second/vacation home that they do not rent out the majority of the time (per IRS regulations); or
- A property that your client held or wants to acquire with the intent of flipping or developing it for sale. Property held primarily for sale is considered inventory.
To have no tax consequence and defer all gain, three criteria must be met:
- The cost of the replacement property must be equal to or greater than that of the relinquished property, and
- All of the proceeds from the sale (“proceeds to seller” at the bottom of the closing statement) must be put into the exchange escrow account and used to purchase the replacement property (not just the gain after the basis is deducted), and
- They must acquire equal to or greater than the amount of debt on the replacement property as what was owed on the relinquished property. This can be accomplished with either a loan or bringing cash to the table. Any difference in these three amounts could cause the exchange to be partially taxable.
Meeting these three criteria can also be accomplished by purchasing more than one replacement property. The amounts are cumulative.
Your client can receive some of the cash from the sale at the time of closing if they want to use it for something else, but it will be taxable. This is called a partial exchange. They cannot pull out the initial money they invested (their basis) without triggering gain.
Your client can’t take the title to the replacement property in a different tax name than the relinquished property. For example: If John Doe (alone) was the seller of the relinquished property, then John Doe (alone) must also be on the title of the replacement property, with one exception. He could also use a disregarded entity, such as a single member LLC so long as he is the sole member. The same goes for a relinquished property owned in the names of a husband and wife. Since Texas is a community property state, they can have the replacement property purchased in the name of their LLC as long as they are the only two members. This same taxpayer rule can cause problems for partnerships when not everyone wants to buy the replacement property, and someone wants to cash out their portion of the proceeds.
The same taxpayer rule applies to the name on the title. For 1031 purposes, it does not matter if someone else is also on the loan. They just can’t be on the title of the replacement property if they weren’t on the title for the relinquished property.
Your client has 45 days from the date of sale (of the first relinquished property) to formally identify (ID) the replacement property(ies) with their QI. They also have 180 days from the date of sale to purchase all of the replacement property(ies). They cannot extend either of the deadlines. The only exception occurs if they are considered to be affected by a Presidentially declared natural disaster.
Further, your client will have 180 days to complete their exchange or until the date their tax return is due, plus extension, whichever comes first. This situation occurs when the relinquished property closing date is towards the end of the tax year and the replacement purchase happens during the following tax year. If they are not going to be able to buy the replacement property before their tax deadline, they will need to file an extension and then close on the property (within 180 days). Once it has closed, they can file their tax return for the preceding year.
To properly execute the 45-day ID letter, the list of identified properties must fall within one of these parameters:
- THREE PROPERTY RULE: Identify up to three (3) properties of any value and buy any one, two, or three of them; or
- 200% RULE: Identify four (4) or more properties with a total aggregate value no greater than 200% of the total value of all relinquished property; or
- 95% RULE: Identify any number of properties of any value as long as the taxpayer then acquires at least 95% of the total value of the identified properties.
Your client can’t change or make a substitution to their ID letter after the 45-day deadline has passed. It is a firm rule. Changes and complete revocations are allowed up until midnight of the 45th day, however.
Your client can’t buy replacement property from a related party unless the related party is also doing a 1031. Additional considerations apply and would need to be discussed with a QI to confirm if it is possible.
In the process of selling the relinquished property, your client can receive and deposit the earnest money, but they will need to make sure that they refund the earnest money during the closing, or they will have to pay tax on that amount of cash.
Your client can’t ask for their exchange funds to be returned anytime they choose. There are very specific rules that govern when funds in the exchange account can be distributed.
Although it may seem like a good option, offering seller financing on the property being sold is not recommended. Owner financing, aka, an “installment sale note” and can cause tax issues. Since all of the gain must first be allocated to the note, your client could lose most, if not all, of the tax benefit of doing a 1031.
1031 exchanges are one of the best tax deferral strategies available to real estate investors. Knowing when your client might benefit from doing one and the basic rules that need to be followed provides quantifiable value to your clients. There are many other situation-specific factors and rules that might affect your client than what was listed above, but understanding this information can help you point them in the direction to get started and help them avoid being put in a potentially adverse taxable position. Because who wants to pay more in taxes than they have to?