1031 Exchange

A 1031 exchange is simply a method by which a real property owner disposes of one property and acquires another without having to pay capital gains tax on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property, as well as paying the recapture of previously taken depreciation. In an exchange, the tax on the exchange is deferred indefinitely.

1031 Exchange Requirement

The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031.

200% Rule

Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property

3-Property Rule

The taxpayer may identify up to 3 potential replacement properties, without regard to their value

95% Rule

The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.

Accomodator

An accomodator is another term for a Qualified Intermediary.

Boot

Boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property. Boot is characterized as either "cash" boot or "mortgage" boot. Realized Gain is recognized to the extent of net boot received.

Boot Netting Rules

• Cash boot paid offsets cash boot received
• Cash boot paid offsets mortgage boot received (debt relief)
• Mortgage boot paid (debt assumed) offsets mortgage boot received
• Mortgage boot paid does not offset cash boot received

Build-to-Suit 1031 Exchange

A Build-to-Suit 1031 Exchange is similar in concept to a reverse exchange. The taxpayer is not permitted to build on property she already owns. Therefore, an unrelated party or parking entity must take title to the replacement property, make the improvements, and convey title to the taxpayer before the end of the exchange period.

Cash Boot

Cash Boot is any boot received by the taxpayer, other than mortgage boot. Cash boot may be in the form of money or other property.

Delayed 1031 Exchange

This is the most common type of exchange. A Delayed Exchange occurs when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. A Delayed Exchange is subject to strict time limits, which are set forth in the Treasury Regulations.

Disqualified Person

A "disqualified" person is any one who has a relationship with the taxpayer that is so close that the person is presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the taxpayer’s attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property. The identification cannot be made orally.

Like Kind

Replacement property acquired in an exchange must be "like-kind" to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.

Mortgage Boot

Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he is relieved of debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in the transaction.

Multi-asset 1031 Exchange

A multi-asset exchange involves both real and personal property. For example, the sale of a hotel will typically include the underlying land and buildings, as well as the furnishings and equipment. If the taxpayer wants to exchange the hotel for a similar property, he would exchange the land and buildings as one part of the exchange. Prior to 2018, the furnishings and equipment could be separated into groups of like-kind or like-class property, with the groups of relinquished property being exchanged for groups of replacement property. Starting in 2018, Section 1031 no longer allows tax deferred exchanges for personal property.

Personal Property Exchange

Prior to The Tax Cuts & Jobs Act of 2017, personal property could also be exchanged for other personal property of like-kind or like-class. However, one of the changes made in the 2017 tax relief act was the elimination of Section 1031 for personal property.

Proper Purpose

Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer's personal residence will not qualify.

Qualified Intermediary (QI)

A Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person.

• Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.
• The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.
• Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.

Qualifying Property

Certain types of property are specifically excluded from Section 1031 treatment. In general, if property is not specifically excluded, it can qualify for tax-deferred treatment.

Examples of excluded properties:

• property held primarily for sale
• inventories
• stocks, bonds or notes
• other securities or evidences of indebtedness
• interests in a partnership
• certificates of trusts or beneficial interest

Realized Gain

Realized gain is the increase in the taxpayer's economic position as a result of the exchange. In a sale, tax is paid on the realized gain.

Recognized Gain

Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.

Reverse 1031 Exchange

A reverse exchange, sometimes called a "parking arrangement," occurs when a taxpayer acquires a Replacement Property before disposing of their Relinquished Property. A "pure" reverse exchange, where the taxpayer owns both the Relinquished and Replacement properties at the same time, is not allowed. The actual acquisition of the "parked" property is done by an Exchange Accommodation Titleholder (EAT) or parking entity.

Tax-deferred Exchange

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

Simultaneous 1031 Exchange

The exchange of the relinquished property for the replacement property occurs at the same time.