Real estate investors have used 1031 Exchanges as part of their investment strategy for decades. In the Summer of 2020, the Biden Administration stunned the industry when it announced plans to impose limits on them, sparking concern in the real estate investment industry.
So, what exactly is a 1031 Exchange and why is it important to investors? In order to answer these questions, let’s take a look at some of the basic components of a 1031 Exchange, the proposals presented by the Biden Administration and the reaction from the real estate investment industry.
1031 Exchange Explained
A 1031 Exchange, a name derived from Section 1031 of the Internal Revenue Code, is a real estate investing tool that allows investors to defer capital gains tax, which is generally required upon the sale of business or investment property, by placing the proceeds in a replacement property. The transaction must be a like-kind exchange, meaning the property sold and the replacement property have to be similar in nature and character, but not necessarily the same quality or grade. For instance, an improved single-family property held for investment could be exchanged for an unimproved single-family property held for investment. Likewise, a ranch or farmland held for investment can be exchanged for single-family rentals used for business or investment purposes. Properties used primarily for personal use, such as a primary residence, a second home or a vacation home, do not qualify as a like-kind exchange.
The Internal Revenue Service (IRS) requires investors to use a Qualified Intermediary (QI) to facilitate a 1031 Exchange transaction. A QI is an independent person or entity that has entered into a written agreement to facilitate the exchange with the investor (or exchanger). Under U.S. Treasury regulations, a QI can be any person who is not the exchanger or a disqualified person. The QI generally performs the following tasks:
1. Prepares the documentation necessary to properly structure the 1031 Exchange.
2. Holds the proceeds from the sale of the relinquished property until the investor closes on the replacement property.
3. Ensures that the 1031 Exchange complies with IRS rules and regulations.
Essentially, the QI works with a closing agent and title company to help coordinate the transfer and acquisition of the properties and handling of the funds. It is important to enlist the help of an experienced QI to ensure the highest level of expertise and security. If the QI fails to adequately perform or meet IRS deadlines, the 1031 Exchange could be disqualified by the IRS. Although rare, QI scams and fraud can occur. The selection of a QI should not be taken lightly.
Four Common Types of 1031 Exchanges
There are four common like-kind exchanges: delayed; reverse; improvement and simultaneous. Let’s take a look at each one and how they differ.
1. Delayed Exchange: The most commonly used exchange, it occurs when there is a time delay between the sale of the relinquished property and purchase of the replacement property. Once the relinquished property is sold, investors have 45 days to find a replacement property and 180 days to complete the exchange.
2. Reverse Exchange: This type of exchange takes place when an investor acquires replacement property prior to the sale of the relinquished property. In this case, the investor has 45 days to identify the relinquished property and 180 days to complete the exchange. The investor is not permitted to own both properties at the same time, so the IRS offers a safe harbor wherein an Exchange Accommodation Titleholder (EAT) acquires and holds title to one of the properties (a process referred to as “parked property”) under a Qualified Exchange Accommodation Agreement.
3. Improvement Exchange: Also referred to as a construction or a built-to-suit exchange, this type of exchange allows the deferred tax dollars to be used towards improving the existing property or a replacement property. The same 45- and 180-day timelines apply in identifying a like-kind property, making improvements and completing the exchange.
4. Simultaneous Exchange: This type of exchange happens when the relinquished property is sold at the same time the replacement property is purchased.
1031 Exchange transactions are complex, so choosing the right strategy can be difficult to determine. It’s imperative to speak with a tax professional to identify the best 1031 Exchange for your situation.
Identification Rules and Timelines
As described above, an exchanger has 45 days to identify a replacement or relinquished property. The identification must be provided in writing with a purchase agreement and legal description of the property, signed by the exchanger and delivered to the QI. Providing verbal communication to a real estate agent, accountant or attorney is not acceptable under IRS guidelines. The entire 1031 Exchange transaction must be completed in 180 days. Some other identification rules include:
• Three Property Rule: The total number of replacement properties an investor can identify is limited to three potential properties without regard to fair market value.
• 200 Percent Rule: The total number of replacement properties can exceed three, only if the aggregate fair market value of all the identified properties does not exceed 200 percent of the total gross sale price of the relinquished property. For example, if the relinquished property sold for $1,000,000, you would be able to identify as many replacement properties you want, as long as the total value of the properties does not exceed $2,000,000 (200 percent of $1,000,000).
• 95 Percent Rule: This rule allows investors to identify an unlimited number of potential replacement properties, without regard for valuation, if 95 percent of the aggregate value is acquired within the 180-day exchange period. For instance, if an investor sells their relinquished property for $3,000,000, they could identify a multiple number of properties collectively valued at $7,000,000, if they actually acquire $6,650,000 (95 percent of $7,000,000) or more of the identified value.
Investors should consult a tax professional or refer to IRS publications to learn more about the current list of IRS 1031 Exchange rules and timelines.
The Future of 1031 Exchange
In March 2022, the Biden Administration released its Fiscal Year (FY) 2023 Budget, and once again, announced its plans to propose a cap on deferred gain from like-kind exchanges. The tax proposals, similar to those presented over the past two years, seek to limit the amount of gain that can be deferred to an aggregate amount of $500,000 ($1 million for married individuals filing a joint tax return) per year for each taxpayer. According to the Biden Administration, doing so would raise $1.95 billion dollars a year in federal taxes.
1031 Exchange executives contend that the proposed caps on like-kind exchanges would funnel much more than $1.95 billion away from real estate investors, creating a severely negative effect on future real estate values, the success of small investors and the economic standing of local communities, especially low-income communities.
Numerous real estate industry organizations and trade associations, including the American Land Title Association (ALTA), have submitted letters opposing the cap, setting forth reasons the 1031 Exchange process should be preserved. According to ALTA’s one-pager on the topic, 10-20 percent of commercial real estate holdings involve a 1031 Exchange. These exchange transactions occur in both metro and rural areas and have a direct and indirect impact in providing economic, real estate and land conservation benefits. If passed, the proposal would be effective for exchange transactions completed in taxable years beginning January 1, 2023.
Does this mean 2022 is the last year for investors to reap the full benefits of a 1031 Exchange? Only time will tell. In the meantime, investors may find it beneficial to stay informed and consult a tax attorney to determine how to manage their investment portfolios. When it’s time to close on a deal, Old Republic Title is ready to help investors with all of their title and escrow needs.
The information addressed herein is as of May 4, 2022. Old Republic Title, its officers and employees do not provide, and this communication is not intended to be investment, tax or legal advice. Old Republic Title makes no representations or warranties regarding the accuracy of the information or tax consequences addressed herein. You should consult an investment, tax or legal professional of your choosing to advise you of the benefits and risks of your specific transaction.