January 08, 2016

Understanding 1031 Exchanges

What is a 1031 Exchange?

A 1031 Exchange, also referred to as a Starker exchange, allows investors to defer capital gains while trading up to larger or higher quality properties. While there are three types of exchanges, simultaneous, reverse, and deferred – deferred exchanges account for 95 percent of these types of transactions. When selling a property the code allows a seller 45 days from the close of escrow of the relinquished proper (“down leg”) to identify the properties (“up leg”), and an additional 135 days to close escrow on the replacement property or properties. The seller must contract with a neutral third party, known as a qualified intermediary or accommodator to hold the funds from the sale of the relinquished property for the seller’s benefit.

 

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Identification

There are three available identification rules named the three property rule, the 200% rule, and the 95% rule. Before finalizing their property ID, the Seller or Exchanger must choose which rule he or she is going to follow.

  1. If the Three Property Rule is chosen, Exchanger may only identify up to three properties. It is not necessary to specify the purchase price using this rule.
  2. If the 200% Rule is chosen Exchanger may identify an unlimited number of properties, however, the total value of the properties identified may not exceed 200% of the value of the Relinquished Property or Properties sold for the subject exchange. If the 200% Rule is chosen Exchanger must state the fair market value of each of the replacement properties identified.
  3. If the 95% Rule is chosen Exchanger may identify an unlimited number of properties, regardless of value. However, Exchanger must acquire 95% of the value of all properties identified. This rule may have the effect of requiring Exchanger to acquire all properties identified.

In addition to meeting the time restrictions and ID guidelines, the exchanger must meet certain other guidelines to defer 100% of the capital gains tax on the relinquished property:

  • Replacement property must be “like-kind” to the relinquished property. For real property, “like-kind” is any property held for investment or used in a trade or business.
  • The up-leg or replacement property must be of equal or greater value.
  • Exchanger must obtain the same or greater debt on the replacement property as was held on the relinquished property.
  • All equity must be reinvested into the replacement property.
  • Exchanger must take title to the up-leg property in the same manner that they held title to the down-leg property. Individuals, LLCs, Partnerships, Trusts, and Corporations can all execute 1031 exchanges.

 

Note that if some of the above guidelines are not met in their entirety a partial exchange may still be possible. For example, if an owner sells a property for $4,000,000 with no debt and purchases a new investment property for $3,000,000 he or she would have to pay capital gains tax on the $1,000,000 of proceeds that were not reinvested. As a second example, if an owner sells a property for $7,000,000 with $2,000,000 of debt on the property he or she would be netting proceeds of $5,000,000. If that same owner buys a new property for $6,000,000 he or she would still have to pay capital gains tax on $1,000,000 because the full amount of debt was not replaced on the up-leg property. There are many scenarios and unique situations that a team consisting of an experienced QI, a trusted tax advisor, and a knowledgeable broker can walk you through.

1031 Exchanges are a valuable tool for building wealth but they do require advance planning and consideration. The Iacono Retail Group is here to assist you in making your first or you fiftieth 1031 exchange a smooth one.

 

Neither Marcus & Millichap nor The Iacono Retail Group is qualified to provide tax or legal advice. Investors should consult with a qualified tax or legal professional regarding 1031 exchange and tax related issues.