Learn the essential rules and timelines for completing a successful 1031 exchange. Origin Investments’ Mike O’Shea explains key IRS requirements, common mistakes to avoid, and how to structure your exchange to fully defer capital gains taxes.
What Is a 1031 Exchange?
When facilitating a 1031 exchange, there are many rules of the road that you must follow. These are very strictly enforced by the IRS. Typically, somebody doing a 1031 exchange is making the largest financial decision of their entire lifetime. And so it’s very important that you have your ducks in a row and that you have the proper advisors to walk you through your 1031 exchange so that you don’t make a mistake and end up having a tax bill.
Key IRS Rules & Deadlines
First and foremost, most people are aware of the timeline. From the time you sell an investment property, you have 180 days to roll the proceeds into a relinquished property. But more importantly, I think people forget about the 45-day rule. That is to say, you have 45 days from the time you sell your property in which to identify a replacement property. After that 45 days is up, you can only close on properties which you’ve identified. That means if you sell on January 1st, you have until February 15th to identify a replacement property. That is light speed in commercial real estate.
Like-Kind Property & Value Requirements
The second, I think, is like kind for the purposes of an exchange. Like kind doesn’t mean that if you sell raw land you have to invest in raw land or hotel for hotel. It just means that you have to sell real property held for investment purposes for the same. So you could sell a hotel and roll it into an apartment building. You can also, in a securitized way, sell your property and roll the proceeds into something like a Delaware statutory trust or a DST. A DST allows investors to pool their capital together and invest into a more institutional property type.
Thirdly, when you’re selling your property, you have to go up in value. Think about it like this: there’s two things you have to do. Number one, you have to roll all of the sales proceeds. You can’t keep any cash in your pocket from the sale. Number two, you have to go up in value. So, if you sold a property for a million and then you rolled it into an $800,000 property, that would be taxable. You could sell a property for a million and roll it up into a $1.2 million property. That would be allowed. So you can always go up in value; you just can’t go down.
Role of a Qualified Intermediary (QI)
You also cannot take constructive receipt of the proceeds, meaning when you sell your property, that cash can never hit your bank account. You have to use something called a qualified intermediary, or basically an escrow agent. So you want to get that set up ahead of time before your sale. At closing, the proceeds from the sale are going to be wired to that qualified intermediary who will hold it on your behalf. That is the person that you will identify the replacement properties with. And then when you’re ready to close on the replacement property, the qualified intermediary will go ahead and roll those proceeds over for you into the second closing.
Finally, continuity of title: the same seller has to be the same buyer in a 1031 exchange. This can become cumbersome for ownership structures like trusts and partnerships. And if not all the members of a partnership want to do an exchange, there are some solutions out there. You can do a partial exchange, you can buy out the other partners, or you can utilize a strategy that Origin offers—a 721 UPREIT—where the partnership does the exchange and then once you’re rolled into the UPREIT, everyone can simply retitle the asset.
Tax Deferral Benefits & Common Mistakes
When calculating the taxes on the sale of real estate, most people are aware of long-term capital gains. But there’s a lot more taxes to be aware of when you’re selling investment property. There’s a net investment income tax of incomes over $250,000—that’s at 3.8%. There’s also state income taxes, which could be irrelevant in zero-tax states, or very high in high-tax states like California and New York. And there’s also depreciation recapture. So if you’ve owned your asset for many years and depreciated it down, that’s a 25% recapture tax on everything that you’ve depreciated since day one.
So, in many jurisdictions, the tax liability is not 20% long-term capital gains. It can be as high as 45 to 50% of the sales proceeds. And utilizing a 1031 exchange defers all local, state, and federal taxes—so there’s zero taxes paid if a 1031 exchange is done correctly.
So there are many other rules that go along with 1031 exchanges. Again, it’s very important to have the proper advisors in place and make sure all of your ducks are in a row. You can learn a lot more about this at our website, origininvestments.com, where you can book a call to speak with me or anyone else on my team.
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