What Is a 1031 Tax Deferred Exchange?
If you have real estate investments, you’ve probably heard of the term, but you may not have a full understanding of what this valuable tax-deferral move can accomplish for you or how it works. Read on for some key terms and tips.
You’ve owned rental properties for years, and while they’ve been good to you, they have also been a lot of work. You’re ready for a change … one that doesn’t leave you with a big tax bill on the sale of your property. Enter the 1031 Tax Deferred Exchange.
Specifically, the tax code referring to 1031 Exchanges in IRC Section 1.1031 reads “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
The 1031 exchange is in effect a tax deferral methodology whereby an investor sells one or several “relinquished properties” for one or more like-kind “replacement properties” and defers the tax liability of capital gains. Tax deferral of capital gains can be an incredible wealth creation tool for real estate investors seeking to move into bigger, better and/or more expensive properties and asset classes. Moreover, those who are in or near retirement can reap a huge benefit by deferring tax, preserving the “step up in basis” and exchanging equity into passively owned income-producing DST replacement properties.
A Look at What ‘Like Kind’ Means
Let’s begin to look at some of the key words and rules of this important part of the tax code for real estate investors. First of all “like kind” is a nebulous term that confuses many investors, because the property does not have to be “like” at all.
An investor can be selling an apartment, and raw land can qualify as like kind. An investor can sell a rental property and like kind could mean a fractional interest in an Amazon distribution center via a Delaware Statutory Trust. Investors can sell farms and raw land and like kind could mean rental homes or storage facilities. There really is no “like” in the like kind requirement, save for the fact that all of these types of real estate investments are not the investor’s own primary residence.
The Timelines Involved
An investor has 45 days to identify a replacement property and 180 days to close on the new property.
The identification rules to be followed in a 1031 exchange are as follows (an investor uses one of the following three rules, picking the one that best fits their current needs):
- Three Property Rule: Investors are allowed to identify three properties as potential suitable replacements with no restrictions on the market value of such properties.
- 200% Rule: Allows an investor to identify any number of properties for potential purchase/exchange so long as their cumulative value does not exceed 200% of the value of the property being sold.
- 95% Rule: Allows for identification of any number of properties so long as you acquire properties valued at 95% of the properties’ total value or more.
More on ‘Like Kind’
New investment property must be of equal or greater value than the one you are selling. Equity of the new investment property must be of equal or greater value than the equity in the property being replaced. Debt on the new investment property must be of equal or greater value than the debt held on the property being sold unless the investor offsets lower debt on the new property being purchased by adding cash as part of the exchange.
All of the net profit from the property being sold must be used in the purchase of the new investment property. Any cash taken out of the exchange is always considered “cash boot” and would be subject to taxation according to the investor’s taxable income.
The amount by which the equity or debt or property value falls short of the requirement is considered the “boot” and subject to taxation. This concept is true of all forms of the taxable boot regardless if the boot is value, cash or mortgage boot. Expenses and certain fees can have an effect on the value of the exchange transaction and in turn the amount of the boot. For example, John sells his rental fourplex for $1.5 million and pays off his $500K loan.
Assuming John’s basis was also $500K, John has $1 million eligible for a 1031 exchange. John needs cash for other things, so he instructs his QI (Qualified Intermediary) to distribute to him $200K (the boot) on which he will owe applicable capital gains tax. John then moves his remaining $800K into DST properties and shelters all of his capital gains.
A Note to Property ‘Flippers’
With real estate today being such a popular investment option, many investors are keen to buy investment properties, rehab them and then “flip” them for a profit. However, the IRS does not allow for this activity as part of the 1031 tax code, so real estate flippers should be advised.
How long one must hold investment property for a 1031 tax-deferred exchange is one of the most commonly asked questions, and the Internal Revenue Code does not state a specific time a property must be held. The IRS has issued more than one ruling, which said that if the property an investor intends to exchange was acquired immediately before the attempted exchange, then the investor will be considered as having purchased the property primarily to resell for a profit, and not held for investment.
In Private Letter Ruling 8429039 (1984), the IRS stated that a holding period of two years would be a sufficient period of time for the property to be considered held for investment. PLRs do not constitute the law; however, many CPAs believe that two years is an adequate holding period. Still other CPAs believe that one year is also a sufficient holding period, with the rationale being that if investment property is held for 12 months or more, the investor's tax returns should reflect such in two tax filing years. Prudent guidelines suggest that one seek professional tax guidance.
Delaware Statutory Trusts or DSTs as Replacement Property
Real estate investors today have options that have not always been available. In 2002 the state of Delaware passed the Delaware Statutory Trust Act, which was groundbreaking. Revenue Ruling 2004-86 soon followed and allowed for DSTs to qualify as “Replacement Property” for the tried-and-true 1031 Exchange.
DSTs could mean to some investors a huge win for someone who is ready to sell but still wants to save/defer capital gains. For example, an investor may no longer want to deal with the headaches and hassles that often come along with income-producing real estate, but they can’t stand the thought of writing that big check to the IRS for capital gains … the proverbial “rock and a hard spot.”
Today investors can now sell their property and defer all of their capital gains using a 1031 Exchange and use a passively owned DST for their replacement property. In doing so, all capital gains can be deferred. Regular monthly cash flow distributions are usually part of the arraignment for most DST offerings.
Here’s an Example of Using a DST
Instead of going out and finding another ranch, apartment complex or hotel to manage, an investor can now select from fractionalized institutional-grade real estate offerings and effectively “outsource” all of the management, reporting, maintenance, midnight phone calls, hassles and headaches that landlords often lament.
DSTs are for when an investor is ready to pass the control along to someone else but still wants the tax-favored income that comes along with owning income-producing real estate. DSTs are pass-through entities, and fractional owners are allowed to participate in depreciation and amortization, which often means that investors are able to shelter much of their monthly DST income from taxation in the same way they would if they were a direct owner/manager. Many DST properties are capitalized with $100 million or more and are syndicates from large national institutional-quality companies.
DST replacement properties are often medical buildings, class multifamily apartment buildings, senior living, student housing, storage portfolios and industrial warehouse buildings. Nationally known tenants are typically companies such as Walgreens, Hilton, Amazon, Walgreens and Kroger’s, among others. Often investors may feel better with a large and stable company, such as Amazon, guaranteeing a lease, rather than the tenants who last skipped out on the rent, leaving them high and dry.
Who Can Invest in a DST?
According to the Securities and Exchange Commission only an Accredited Investor, which is an individual with a net worth in excess of $1 million, excluding his or her home, OR an individual with income over $200,000 over the last two years, can invest in a DST. If married, the combined income required is $300,000. The income is required to be “reasonably expected” going forward.
Other Accredited Investors under SEC Rule 501 include:
- Certain trusts with assets of at least $5 million.
- A bank, insurance or certain registered investment companies.
- Certain employee benefit plans and certain tax-exempt charitable organizations, corporations or partnerships with assets exceeding $5 million.
- Certain family trusts and pass-through entities, such as LLCs, S Corps, and LLPs.
A Qualified Intermediary is required in a 1031 Exchange by the IRS and the (QI) services MUST be involved before the closing of the sale of your investment property. Most real estate agents, title companies, attorneys or investment advisers can refer you to a Qualified Intermediary, who acts as a third party compliance expert to keep your exchange within the rules and boundaries of the IRS. The importance of engaging the QI before your sale cannot be stressed enough.
About the Author
Chief Investment Strategist, Provident Wealth Advisors
Daniel Goodwin is the Chief Investment Strategist and founder of Provident Wealth Advisors, Goodwin Financial Group and Provident1031.com, a division of Provident Wealth. Daniel holds a series 65 Securities license as well as a Texas Insurance license. Daniel is an Investment Advisor Representative and a fiduciary for the firms' clients. Daniel has served families and small-business owners in his community for over 25 years.